Investment risk is simply the likelihood or probability that an investor may incur losses instead of profit on an investment. It is a measure of the uncertainty in the realization of the returns relative to the expectations of the investor.
Every investment involves risk, and some investments may be riskier than others due to higher possibilities of losses. Losses in investment can be caused by factors such as a fall in investment value or unexpected market performance.
How Does Investment Risk Work?
Investors measure the risks associated with investment to be able to decide whether the investment is worth the risk or not. The risks tell you the possibilities that the investment may not eventually turn out as expected.
Typically, investors seek higher returns on investments with higher risks to compensate themselves for taking such risks. Failure in investments with high investment risks may result in low profit, no profits at all, or even loss of capital. On the other hand, high investment risks may increase the chances of making higher returns.
As such, investors are expected to take investment risks according to their risk tolerance level, which is your ability to cope with investment failures. Factors such as age, experience, capacity to recover, financial goals, etc., may combine to determine an investor’s risk tolerance.
What Are the Basics of Investment Risk?
It is necessary that every investor understands the risks associated with the investments they intend to make.
What Is an Example of Investment Risk?
Suppose an investor invests in a foreign country. Foreign investments come with a risk of currency depreciation. If the country of investment is at risk of falling GDP or inflation, chances are that the investor may lose money due to a decrease in the value of the investment.
Systematic vs Unsystematic Risk
A systematic risk is such that is inherent in the whole market or market segment. Unlike unsystematic risks, systematic risks arise from external factors and apply to the whole market, not just a particular industry or stock. Examples of such risks include tax changes, inflation, etc.
On the other hand, unsystematic risks are associated with a particular stock or industry. It does take its bearing on the entire market. Such risks are industry-specific and can be controlled by internal actions within the affected organization. Factors that contribute to unsystematic risks include internal labor strikes, production of unfavorable products, etc.
Systematic Investment Risks
Most systematic risks are difficult to control at the organizational level because the impact is usually market-wide. Systematic risks include:
A market risk is the possibility of an investment depreciating in value due to economic reasons that affect the entire market. Market risks are not industry-specific, and may not be properly managed by diversification. There are three types of market risks, and they are as follows.
This is a risk associated with an investment in shares. It is the risk of possible loss in investment due to a downward fluctuation in the market price of shares. This risk exists because the market price of shares varies with changes in demand and supply.
For investors, this introduces a possibility of a reduction in the value of shares. Eventually, it may result in a loss in investment if the price drop is a major one or lasts for a long time.
Interest Rate Risk
This type of investment risk is associated with debt investments. An example of such investment is bonds. Interest rate risk is the risk of loss in investment as a result of a change in interest rate.
Interest rate is inversely proportional to the market value of bonds. This implies that an increase in the interest rate of your bonds results in a drop in the market value of the bonds.
Currency Risk (Exchange Rate Risk)
Currency risk, also known as exchange rate risk, applies to international investments. It is the possibility of losing money on your investment as a result of fluctuations in currency values and exchange rates. The value of your stock in one country may be affected by movements in the general exchange rate.
For instance, an increase in the value of Canadian dollars against U.S dollars will decrease the value of your stocks in U.S dollars. As such, you can monitor exchange rate movements and align your foreign investments to make more profits.
Inflation Risk (Purchasing Power Risk)
Inflation, over time, decreases the purchasing power of money. This implies that a certain amount of money can only buy less than its normal purchasing value during inflation. Therefore, inflation risk is the risk of loss in investment value due to price increase.
Inflation risk may not bother you much if your investment is in shares or real estate. Companies and landlords can increase their prices to correspond with the current market value. It applies mostly to investments in cash or debt investments such as bonds.
This is a risk of investment loss as a result of investing all your money in one place or one type of investment. Any loss on that investment implies a loss on all your investments. To mitigate this risk, you need to diversify your investments, thereby spreading your risks across different types of investments and industries.
This is the risk of the inability of a company or government entity to fulfill their bond responsibilities due to financial difficulties. In such cases, the issuer of the bond may not be able to pay the bond investors. If you invest in bonds, you may need to evaluate the credit rating of a bond issuer before making investments.
This risk applies mainly to pensioners and retirees. It is the possibility that an investor will outlive the expected duration. The risk bears its implications on insurance companies and pension funds. They may eventually get to pay more than estimated if the investor stays longer than the expected time.
Foreign Investment Risk
This is the risk of losses incurred in investment in foreign countries. If you invest in a country with a falling GDP or high inflation, you’re most likely to lose money. Also, some risks exist in some places without existing in other places. For instance, investing outside Canada may attract other risks such as marginalization.
Unsystematic Investment Risks
Unsystematic investment risks apply only to specific investments, industries, or commodities. Such risks include:
This is a possibility that investments may not yield the expected returns as a result of political adjustments or instability. Political changes such as changes in policy and change of government may affect the return rate of an investment. This type of risk is also known as geopolitical risk.
This is a risk associated with the inability of a firm to generate enough profits. To be able to make profits, a company should at least be able to settle its common expenses such as payroll, marketing, etc.
Liquidity risk measures the risk of the inability of a company to sell securities at a profitable price and convert them to cash. When the market liquidity is low, you may resort to selling at cheaper rates and that reduces the value of your investment returns.
What Is Risk Management and Diversification?
Risks are a part of every business and investment. Risk management intends to identify, analyze, and either accept or make efforts to reduce the risks associated with an investment. Some investment risk management techniques include the following.
Spread Your Portfolio Among Different Investments
Risks such as concentration risk arise as a result of investing your money in one place. If you invest that way, losses in your investment may mean that you lose everything at once. To avoid this, you can spread your capital across different investments.
For instance, if you have only bonds, it may be necessary to also buy shares, stocks, mutual funds, cash, ETF, ADRs, REITs, etc. As such, you may be able to recover from the loss on one type of investment with a profit on another one.
Diversify Your Investments
Just like spreading your portfolio into different investments, it’s also safer to invest in different industries, sectors, and locations. For instance, your investment in agriculture may come to your rescue when there is a drop in your investment value in stocks.
Also, different places may experience opposite economic movements sometimes. Say you invested in both Canada and the U.S, for instance. While a drop in the value of Canadian dollars may cause you losses, it may correspond to a rise in the market value of U.S investments.
Invest In Different Stocks
Different stocks have different levels of risks inherent in them. Companies that have built a good and strong reputation over time may seem safer for investments.
However, it is not always the case. It is safer to invest in different stocks and at different risk levels. You can maximize the investment offers from companies who are trying to build up.
Are There Any Guarantees With Your Investments?
Investments may be guaranteed when they are insured. According to the United States Security and Exchange Commission, different agencies guarantee different kinds of investments.
Deposits of members of federally insured credit unions are insured by the National Credit Union Share Insurance Fund (NCUSIF) established by the National Credit Union Association. Insurance by the Share Insurance Fund covers up to $250,000 for individual accounts.
Likewise, the Securities Investors Protection Corporation (SIPC) insures the stocks and other securities of members of its member firms against losses. The insurance can cover up to $250,000 in cash and up to a total of $500,000.
It is not enough to know or find out investments to make more profit. As a profitable investor, you also have to identify, understand and evaluate the risks associated with your Investments. We recommended that you engage the services of a professional financial advisor for expert counsel on how to minimize the risks of investment.