Investment risk is defined as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment.
Why Investment Risk is Important to Understand
An important aspect of investing is understanding the types of investment risk and the potential impact on your portfolio. It is a given that an investor must take risk in order to achieve rates of return above a risk-free rate of return. The risk-return tradeoff is the balance between the desire for the lowest possible risk and the highest possible returns. In general, low levels of risk are associated with low potential returns and high levels of risk are associated with high potential returns. Each investor must decide how much risk they are willing and able to accept for a desired return. This will be based on factors such as age, income, investment goals, liquidity needs, time horizon, and personality.
The Two Main Categories of Investment Risk
Market risk, also known as systematic risk, is risk affiliated with market returns. These can include macroeconomic factors such as interest rates, inflation, recessions, currencies, politics, etc.
In the short-term stock market prices cannot be predicted. But long-term returns can be predicted with some accuracy. In other words, the variation of returns (risk) is less over long periods of time than short periods of time.
Long term market returns are inversely correlated with valuations. This is why investors should use a tactical asset allocation which invests more in assets when they are selling at bargain prices and less aggressively when valuations are high. A long-term investment horizon together with an active asset allocation strategy allows an investor to partially mitigate market risk.
Specific risk, also known as unsystematic risk, is risk that is not correlated with market returns. It is the risk that is specific to a particular company or industry. An individual investment, such as a company, can have problems that are specific to that asset. Maybe a catastrophe (i.e. BP oil spill), bad management, a large product failure, etc. causes the individual assets price to fall. Diversification can be used to mitigate specific risk by investing in a variety of assets.
Specific Types of Investment Risk
- Sociopolitical Risk — This involves risk related to political and social events such as a terrorist attack, war, pandemic or elections that could impact financial markets. Such events, whether actual or anticipated, can affect investor attitudes and outlooks, resulting in system-wide fluctuations in stock prices.
- Interest Rate Risk –Changes in interest rates directly affect the value of bonds. When interest rates rise the price of bonds decline. Interest rates also affect economic activity and borrowing costs.
- Credit or Default Risk – Sometimes a borrower is unable to pay back debts or bills.
- Inflation Risk – Inflation risk is the risk that general increases in the prices of goods and services will reduce the purchasing power of money, and likely negatively impact the value of investments.
- Economic Risk – Economic recessions and depressions can have profound effects on asset valuations.
- Liquidity Risk – If you need to sell an investment you may not be able to find a buyer in a timely manner. Most publicly traded equity and bonds are fairly liquid. But many alternative investments such as real estate, artwork, coins, stamps, etc. may experience periods when they are illiquid.
- Country Risk – The risk that a country will not be able to honor its financial commitments. When a country defaults on its obligations, it can harm the performance of all other financial instruments in that country – as well as other countries it has relations with.
- Regulatory / Political Risk – Governments have a large effect on social stability and the economic environment for investment. Look for political stability and business friendly policies.
There are many factors that can affect risk and there are portfolio management strategies to measure and mitigate risk factors. Understanding the types of investment risk allows an investor to manage risk and potentially optimize outcomes. To learn more about how we can help you do this, contact us at 301-907-9790.