All investments come with risks. When you invest, you also chose to deal with the accompanying investment risk.
Investing in a broad stock market index fund with a long-term prospect may be the right approach, but it does not mean that it is risk-free.
If your goal is to build wealth over time, you have to take on a substantial amount of risk. Accepting a bit of risk will only leave you with no buying power over the long term, as prices of products rise.
Identifying and assessing the potential risk involved in any investment tends to get a little complicated. To determine whether the investment is right for you or not, take note of these four investment risks.
Also known as systematic risk, a market risk considers universal factors that affect the overall performance of economies or financial markets in which you are involved.
If you chose to invest through a less expensive means of investing in a broad stock-based index fund, you have to accept that your investment’s value could drop, due to overall economic condition of the country or the world.
Market risk has four different types, including equity risk, interest rate risk, currency risk, and commodity risk.
- Equity Risk – This risk stems from the volatility in stock prices. Market price of shares always differs, depending on demand and supply. Therefore, equity risk is the possibility of you experiencing a loss due to a decline in stock prices.
- Interest Rate Risk – Interest rate risk is the potential of you losing money as a result of a change in the interest rates. Debt investments, such as bonds, are usually exposed to this kind of risk. If rates go higher, the market value of bonds will then fall.
- Currency Risk – Applies when you are holding foreign investments. Currency risk arises from the rise and fall of currency exchange rates. For example, if the US dollar becomes less valuable than the yen, the value of your US shares will then be smaller when converted to yen.
- Commodity Risk – People who both use and manufacture commodities are equally affected by this. Commodity risk is the uncertainty caused by unexpected changes in the price of a certain commodity.
For example, if crop prices are low at one year, a farmer can plant a fewer amount of that crop. However, if the prices go up the following year, the farmer will be unable to acquire the benefits from that crop.
Market risks could be difficult to manage or predict. They cannot be diversified away, although they can be hedge against.
Incidents like economic recessions, political dispute, changes in interest rates, natural calamities, and terrorist attacks are some of the major sources of a market risk.
Default risk is the potential for companies or individuals to be unable to fulfill their obligation to make timely principal and interest payments.
Investing in corporate bond offers higher return than a savings account, but it exposes you to the risk of default. That means you might not receive the return you were originally promised, if the company does not perform well, or files for bankruptcy.
While pension funds are considered as secured investments, they are not entirely safe from a default risk. A company may guarantee all retirees access to free health care. That benefit, however, could still fade away once the business restructures.
Lenders usually charge rates of return that goes with the debtor’s level of default risk to minimize its impact. A higher risk could result to a higher return.
Inflation risk occurs when the value of securities cash flow falls because of inflation, which is measured in terms of purchasing power.
If you are holding cash, savings accounts, or bonds, you are likely to face this type of risk. The danger with inflation is that these assets might not mature enough to allow you to realize your long-term financial goals.
Financial planners usually believe that inflation runs around 3 or 4 percent annually for a very long time. This type of thinking provides investors the opportunity to estimate possible real return for an investment.
For example, if you assume inflation is 3 percent and your savings account earns an annual percentage yield of (APY) of 1 percent, your actual return is a loss of 2 percent per year. The real return considers the effect of inflation.
Inflation-protected bonds, such as Treasury Inflation Protected Securities (TIPS) are your means of protection against this kind of risk. Floaters help mitigate inflation risk due to changes in interest rates. All other bonds will leave you vulnerable to this risk, as interest rate is set for the life of the bond.
Shares also offer some security against inflation, as most businesses can raise the prices they charge to their customers. Real estate can protect you from inflation risk as well, since landlords can increase rents over time.
Mortality risk is the potential of you outliving your savings. This risk usually runs in investments, mainly including annuity, pension, insurance, contracts, and other investments with a long-term perspective.
While your annuity payments or distributions to you go on as long as you are alive, the risk of dying before you can even have an ample amount of your benefit to make the premium payments and fees worth the effort is present as well.
Mortality risk is not only an investment risk related to holders of annuities, who are living longer than expected. It is also the risk of a recipient dying earlier than anticipated during the time period of the policy.
If you have tried to sketch your financial life, with the aim of fully using your fortune during retirement, and you ended up outliving your wealth, you create the risk of losing all your money.
Managing Investment Risk
Even though an investment risk cannot be eliminated, there are two basic strategies that can help tackle it:
Asset allocation involves the process of spreading your portfolio among different types of asset classes to maximize the return for a specified level of investment risk.
The goal here is to keep the risk and reward balance by including various asset classes in your portfolio. That should help raise the returns on some of your investments even if the others are not performing well.
There is no simple procedure to identify the asset allocation suitable for every investor. However, several financial professionals agree that asset allocation is one most significant decision that investors make.
Diversification is simply the act of not putting all your investment eggs in one basket. It is a risk management strategy, where the investor attempts to lower the volatility and therefore, the risk, of his/her portfolio by having a variety of investments that are not completely correlated.
With diversification underscoring variety, you will be able to spread your assets around.
The fundamental idea behind this is that the good performance of some of your investments offsets the negative performance of your other investments. That is why, your securities must not move together. The less correlated they are, the better.
For instance, if you invest in a bank stock, a grocery stock, and a healthcare stock, you would be investing in stocks that do not have much correlation with each other—that is, what influences one does not necessarily affect the other.
Note: You can also tackle an investment risk through hedging or insurance. However, these two methods could increase the costs of your investment, which may spoil returns. Hedging also involves speculative, higher risk activity, such as short selling and investing in illiquid assets.
As discussed above, there are a number of investment risks involved in investing. They may be impossible to remove, but they can certainly be contained.
By having a better grasp on the nature of risk and taking the appropriate measures to manage that investment risk, you increase your chances to achieve your financial goals.
If you want to learn new things and learn strategies about the market, BWorldpedia is the site you should visit! We provide profound and useful insights about the market and across a plethora of topics related to it. Also, register an account now with BWorld and start your investment journey.