An investment is an asset or item that someone gains to generate income or appreciation. Appreciation is the increase in an asset’s value over time. When someone purchases goods as an investment, the goal is to use the goods in the future to create wealth. Investments always relate to the outcome of capital (time, effort, and money) in hopes of a greater payoff in the future than what was initially put forth. Some examples of investments include bonds, stocks, real estate property, or businesses.
Investment risk is the possibility or uncertainty of losses rather than the expected profit from an investment. It occurs based on various factors, such as a fall in the fair price of securities (bonds and real estate). Other effects include a loss on the invested amount or the money invested never returning to the investor. In terms of investment risks, there are nine main types. Learning about each and their impact can help you make better investment choices.
The nine types of investment risks are listed below.
- Credit Risk
- Market Risk
- Liquidity Risk
- Reinvestment Risk
- Inflation Risk
- Concentration Risk
- Longevity Risk
- Horizon Risk
- Foreign Investment Risk
1. Credit risk
Credit risk applies to the risk of default on bonds given by a company or the government. The bond issuer may endure financial hardship, which means it may not be able to pay the interest or principal to the bond investors. As a result, the issuer will default on its obligations. Credit risk mainly applies to debt investments like bonds. One way to gauge the risk is by looking at the credit rating of a bond.
2. Market risk
Market risk is the possibility of investments declining in value due to economic developments or other events that impact the entire market. There are three main types of market risk (equity, interest rate, and currency). Equity risk relates to an investment in shares. The market price of shares varies often based on demand and supply. Equity risk is the risk of loss due to a drop in the market price of shares.
Interest rate risk applies to debt investments like bonds and is the risk of losing money since a change in the interest rate has occurred. For instance, if the interest rate goes up, the market value of bonds will drop. As for currency risk, this pertains to people owning foreign investments. It is the risk of losing money due to movement in the exchange rate. If the U.S. dollar becomes less valuable relative to the Canadian dollar, your U.S. stocks will be worth less in Canadian dollars.
3. Liquidity risk
Liquidity risk is not being able to sell securities at a reasonable price and convert them into cash. Since there is less liquidity in the market, investors may have to sell securities at much lower prices. Therefore, they are losing value. In certain cases, such as exempt market investments, it may not be possible to sell the investment at all.
4. Reinvestment risk
Reinvestment risk is the chance of losing higher returns on a principal or income due to the low rate of interest. Suppose you purchase a bond paying 5%. In that case, the reinvestment risk will affect you if rates drop, and you have to reinvest the regular interest payments at 4%. Reinvestment risk also applies if bonds mature, and you must reinvest the principal at less than 5%. The risk is not applicable if you intend to spend the regular interest payments or principal at maturity.
5. Inflation risk
Inflation risk is the loss of your purchasing power. This occurs since the value of your investments does not keep up with inflation. Inflation erodes the purchasing power of money over time. So, the same amount of money will buy fewer goods and services. Inflation risk especially applies if you own cash or debt investments like bonds. Shares can offer some protection against inflation because most companies can increase the prices that they charge to customers. Hence, share prices should rise in line with inflation.
6. Concentration risk
Concentration risk is the chance of loss on an invested amount because it was invested in only one security or one type of security. For this kind of risk, the investor loses all of the invested amounts if the market value goes down. In this case, the fall of an invested particular security will affect the investor. You can avoid this by diversifying investments, which means you can spread the risk over various types of investments, industries, and geographic locations.
7. Longevity risk
Longevity risk is the risk of outliving your savings. It mainly applies to people who are retired or nearing retirement. This risk occurs because of the increasing life expectancy trends among policyholders, pensioners, and growing numbers of people reaching retirement age. Current mortality rates and longevity trend risk are the two factors in consideration when transferring longevity risk. Trends can produce payout levels that are higher than what a company or fund had initially expected. The easiest way to transfer longevity risk is through a single premium immediate annuity (SPIA). For SPIA, risk holders pay a premium to insurers and pass both asset and liability risks.
8. Horizon risk
Horizon risk is any factor that shortens your investment horizon. One of the best methods of wealth creation is investing for a long time. If you buy a house, lose your job, or get married, those life changes can alter your time horizon for several years or more. If you lose your job for a time until you find another one, that time passes, meaning you lose out on the compounding effect. The same thing pertains to the purchase of a home, and that outlay of money takes away from investments that can compound.
9. Foreign investment risk
Foreign investment risk is the risk you take when investing in foreign countries. The investment will lose money if the whole country has a high possibility of falling GDP, high inflation, or civil unrest. Whenever you buy foreign investments, such as the shares of companies in emerging markets, you can endure risks that do not exist in your country. One example is the risk of nationalization. Always consider how much the risk will cost and how long you plan to invest before acquiring foreign investments.
What is an Investment?
An investment is any asset used to produce income or capital gains. The expectation is that it will provide value in the future that will exceed its initial cost and time to value. This will happen to the appreciation of an asset’s value. Appreciation can result from market condition changes, a change in overall supply, or direct improvements being made. As for the term investment, it can apply to numerous assets, even intangible ones like education. Other examples are stocks, bonds, and real estate. Investments are important since they are excellent tools that provide periodic and regular income. Also, they can help investors generate wealth through their capital over time and benefit people trying to reach long-term financial goals.
What Factors Contribute to Investment Risk?
Investment risk is a concept that can take several years or more to follow through. And it does not apply to one specific thing. Investment risk is a combination of factors under the umbrella of “investment risk.” Numerous people do not begin to understand and learn how to manage it until they have endured it. Therefore, it is crucial for new investors to familiarize themselves with risk before deciding where to put their money.
Five main factors contribute to investment risk.
- Investment Time Frame
- Risk Capital
- Investment Experience
- Investment Objectives
- Actual Investment You’re Considering
1. Investment time frame
Investing toward future financial needs and accomplishing goals requires much effort and technical knowledge. The first step is to identify your financial goals. Afterward, consider your risk appetite and how long you anticipate investing. There are four term periods to choose from (immediate, short-term, medium-term, and long-term). These time frames contemplate market suitability, risk appetite, and expected investment returns. Carefully examine your options and determine which route is best for you based on time and energy needs.
2. Risk Capital
Risk capital is funds allocated to speculative activity. It is often used for high-risk, high-reward investments. Any money or assets potentially exposed to a loss in value is deemed risk capital. However, the term is usually reserved for funds earmarked for highly speculative investments. Risk capital can become more efficient through diversification since the prospect of each is uncertain. You will ensure that only a small portion of total capital is considered risk capital.
3. Investment Experience
Investment experience comes along naturally the more you invest. You become familiar with how things operate, your risk tolerance, and the best investments to choose. Investors typically know how to handle securities such as bonds and stocks, know the ownership of interests in partnerships, and have experience in business and financial dealings. The more you know about investing, the easier it is to navigate certain territories and protect your financial assets. Also, the earlier you start investing, the better. Investing early prepares you more for handling your finances in the future.
4. Investment Objectives
Investment objectives include security of the investments, capital protection, capital growth, and capital multiplication. They are goals you set and tools you use to help you accomplish financial goals. Security (mode and instrument of the investment) should safeguard the investor’s interest, while capital protection shields against the erosion of the amount invested due to market volatility. Then, capital growth concerns the returns on investments per the investor’s expectation. Finally, capital multiplication gauges aggressive allocation of investment funds for higher returns. After your objectives are set, you can look into the best investment period to determine the investment vehicle.
5. Actual Investment you’re Considering
Every investment comes with risk. As soon as you invest your money, you choose to support an asset despite the potential consequences. Ensure you know the investment you are considering and if the reward outweighs the risks. The goal of investing is to gain more financial wealth in the future, so it is best to understand the actual investment you are interested in before putting forth time and effort. Investment goals are important since they can set you on the right path on your financial journey. Ensure you know what your goals are before you start investing.
How to Reduce Investment Risk?
All investments carry risks, but the key is reducing as many of them as possible when deciding. This action will help you years later when you expect to maximize your investment returns. The main goal of your investment portfolio should be to minimize the overall risk and help secure your financial future. So, while it is not very likely to eliminate all the risks of your investments, there are ways to minimize the risks.
The following are several things you can do to reduce investment risk.
- Know Your Risk Tolerance.
Risk tolerance is an investor’s ability to endure losing the capital they invested. It usually relies on the investor’s age and current financial obligations. People in their 20s who are unmarried with no children have fewer financial responsibilities than those in their 50s who are married with college-going children. Therefore, young investors tend to be more risk-tolerant than older ones. The earlier you start investing in life, the more you can focus on growing your wealth and learning your risk tolerance.
- Ensure There is Sufficient Liquidity.
One risk to your portfolio is that you may need to redeem investments when markets are down. You can reduce this risk by maintaining adequate liquidity. Having sufficient liquid assets in your portfolio will enable your existing investments to deliver optimal long-term. And you can benefit from periodic market corrections. A great way to stay prepared is by setting aside an Emergency Fund equal to 9 to 12 months’ expenses.
- Implement an Asset Allocation Strategy.
Asset allocation consists of investing in multiple asset classes in certain proportions to ensure your overall investment portfolio includes minimal risk and optimal returns. Various strategies are available to gauge the perfect mix of key asset classes like equity, debt, gold, and real estate. It would help if you considered investing in a combination of inversely correlated asset classes. This way, you are secure in case one asset class outperforms another. One example of an ideal pairing is equity and gold.
- Diversify Your Investments.
After deciding which asset classes suit your investment objectives, you can reduce the overall risk even more by diversifying your investments within the same asset class. Diversification aims to spread your risk across multiple types of investments within the same asset class, so all of your eggs are not in one basket. For example, you can diversify your equity mutual fund investments by spreading them across multiple mutual fund categories. Some of these include large-cap funds, large and mid-cap funds, multi-cap funds, and Flexi-cap funds. The more you can diversify your investments, the better your odds will be in the future.
- Monitor Your Portfolio’s Performance.
As an investor, you should consider staying invested for the long term. But also, that does not mean you invest and forget. You must keep tabs on your portfolio’s performance and do periodic reviews. However, do not do the reviews too often. An ideal time frame to review your portfolio is once every year. If that seems too long for you, consider adopting the frequency of once every six months because anything less than that can lead to frequent changes.
- Focus on Time in the Market.
Time and the power of compounding are your most powerful wealth-generating tools. Therefore, you must stay invested and maximize your time in the market instead of trying to make a quick buck by “timing the market.” Any risk to your portfolio due to short-term volatility will be notably reduced when you stay invested long-term. It is good to take advantage of lucrative opportunities that arise. Still, long-term wealth creation requires patience and disciplined investing.
How to Deal with Investment Risk?
You cannot eliminate investment risk. Any asset you want to put time and money into will potentially impact your finances negatively. But, there are ways to manage the risks that come with investing.
The following are some ways you can deal with investment risk.
- Asset Allocation.
When you include different asset classes in your portfolio, you increase the odds that some of your investments can offer satisfactory returns. Some examples are stocks, bonds, real estate, and cash. This method applies even if others are flat or losing value. Essentially, you are reducing the risk of major losses that can occur from over-emphasizing a single asset class. It does not matter how resilient you expect the class to be.
When you diversify your investments, you divide the money you have allocated to a particular asset class, such as stocks. Due to its emphasis on variety, this strategy allows you to spread your assets around. Do not put all of your eggs in one basket. If you place too many good things in one area, that will set you at risk of losing more. Creating a well-diversified plan for you will help you manage investment risk
Hedging is buying a security to offset a potential loss on another investment. Insurance can provide extra protection for managing risk. However, this strategy can often significantly add to your investment costs, which eats away at any returns. Moreover, hedging generally involves speculative, higher-risk activity like short selling (buying or selling securities you do not own) or investing in illiquid securities.
Is every Investment at Risk?
Yes, every investment is a risk. Whether it is stocks, bonds, mutual funds, or exchange-traded funds, there is a possibility they can lose all of their value. When you take a risk on an investment, you choose what to do with your financial assets. To make the best decision, you rely on the available options and the information presented to you. As with risk for anything else, there is a chance your financial welfare will be negatively impacted. For instance, your investment can rise or fall due to market conditions. Another factor is corporate decisions, such as whether it is right to expand into a new business area or merge with another company.