Understanding Investment Risks
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Every investor needs to understand that all forms of investments involve a certain degree of risk. Investments such as stocks, bonds, mutual funds and exchange-traded funds have a high vulnerability of losing their values if market condition shifted. Investors need to accept a significant amount of risks in order to build wealth over time. Keeping your money in a high-yield savings account and risk- free investments may decrease the purchasing power of your money over a period of time due to inflation. Thus, the most sensible way of preserving your money’s financial independence is by considering a riskier investment than the savings account.
Types of Investment Risks
Whenever you invest, you make certain choices about what to do with your financial assets. Any uncertainty which may potentially affect your financial welfare negatively is considered as a risk. The market value of your investment may rise or fall depending on market conditions. Big, stable companies have the risk to close and go out of business. There are other types of risks that an investor may encounter in the market. It is important that he should understand them thoroughly to be able to manage them properly.
The possibility that a fixed- rate debt instrument will decline in value as a result of the rise in interest rates is called interest risk. This is relevant to buying securities that offer a fixed rate return such as bonds and preferred stocks.
Also known as unsystematic risk, business risk refers to the risk involved with a specific user of a security. Generally, all types of businesses in the similar industry are vulnerable to the same kind of business risk. However, in a more specific sense, business risk refers to the possibility of the issuer of the security to go bankrupt and lose the capacity to pay the interest or principal of the investment to its investors.
This type of risk involves the possibility that a particular issuer of a bond will not be able to make the expected interest rate payment and/ or principal re-payment to its investors. The higher the credit risk, the higher the interest rate of the bond.
This type of risk typically applies to municipal bond offerings and pertains to the risk that a certain security issued with a tax-exempt status may lose its value as it reached the maturity. Because these types of bonds carry a lower interest rate than fully taxable bonds, investors may end up with a lower after-tax yield.
Inflationary risk involves the chance of losing the financial asset’s purchasing power over time due to inflation devalues the country’s currency. It is the risk that future inflation will cause the purchasing power of the cash flow from an investment to decline.
Liquidity risk pertains to the possibility that an investor may not be able to buy or sell a particular investment as or when desired due to limited opportunities.
Referred also as systematic risk, market risk is the type of investment risk that will affect all securities in the same manner. A market’s crash or decline will affect the performance of the investment, even if the quality of the investment remains the same.
This type of risk refers that the falling interest rates will lead to the decline in cash flow from an investment when the principal and interest payments are reinvested at lower rates. Investors who have bonds coming due or being called face the difficult task of investing proceeds in bonds issues with equal or greater interest rates. Thus, they are forced to purchase securities with a lesser level of income.
This type of risk is associated with any social or political changes that may result in the loss of value of investments. It also includes any changes in legislative decisions that have a direct or indirect effect on securities.
Exchange Rate Risk
Exchange rate risk is a form of risk that involves the change of the price of one currency against another. Constant change in rates of the foreign currency in which the investment is denominated may add risk to the value of the security.
Risk vs. Reward
The level of risk associated with a particular investment correlates with the level of return the investment might achieve. The investors who are willing to lose money on their investment should be rewarded for their risk. In investing, reward equates to a high return on investment. Stocks yield higher average annual returns over a long-term followed by corporate bond and treasury bonds. Albeit, stocks do not always outperform bonds or that bonds are lower risks than stocks. Their return and risk levels may vary depending on the current market and economic conditions and the manner which they are used.
It is also difficult to predict whether the established historical averages will play in your favor. Investors must understand that even if they hold a diversified portfolio of stocks in an extended period of time, there is no guarantee that they will earn them a rate of return equal to the long-term historical average. The timing of the purchase and the sale of investment are the significant determinants of the investment returns.
Managing Investment Risk
Although investors cannot eradicate investment risks, there are ways on how they can be managed. There are two basic investment strategies that can help investors manage investment risk and maintain financial welfare.
This is an investment strategy that targets to balance risk and reward by apportioning a portfolio’s assets in accordance with the investor’s individual goal, risk tolerance, and investment horizon. This is done by including different assets in the investor’s portfolio, thus, increases the probability that some of the investments produce satisfactory return even if others even out or lose their value. The selection of the individual securities is only secondary on the way that the investment is allocated.
Diversification is a type of investment strategy that refers to owning a mix of different investment types to manage the exposure to different risks. When an investor diversifies, he divides the money allocated to a particular asset class among various categories of investment in that particular asset class. The rationale behind this strategy is that a portfolio of different kinds of investment will, on average, yield higher return and cause a lower risk than any individual investment found in the portfolio. The strategy strives to even out unsystematic risk events in a portfolio so that the positive performance of the investment will neutralize the negative performance of the others.
In order for an investor to meet his financial goal, one needs to spend some time in understanding potential investment risks. By having a better understanding of the nature of risks, one can take a step further to manage those risks and be able to maintain a healthy financial asset.
Updated: March 2018