Risk and investing go hand in hand – no matter how safe you think your investments may be. A good investor will try to minimize their risk as much as possible without also reducing their potential rewards – but even the wisest investors must face the occasional downfall.
What exactly is risk? It is any uncertainty in your investments that has the potential to negatively affect your finances – and it comes in all shapes and sizes. Before making any investment, it’s important to evaluate the different levels of risk that are involved, and determine what level you can tolerate.
Market risk, or volatility, is risk that affects all securities in the same way. This type of risk is caused by events that are out of one’s control and affect the entire market, not just a single company or industry type. This means that while the quality of your investments may not change, an outside event causing a market decline could crush your portfolio’s performance. Outside events could be geopolitical – such as the recent Brexit vote, economic, inflation-related, and any other event that cannot be controlled by diversification in your portfolio.
Inflationary risk is the chance that the value of your investments may diminish as inflation diminishes the value of a country’s currency. Ideally, shares should offer some protection against inflation, as companies can usually increase their prices in accordance with the inflation. What really takes a hit are investments like bonds or longer-range CD’s with locked-in return rates. These are especially susceptible to inflation risk because even though interest and principal may be guaranteed, the purchasing power of the principal and interest could be significantly reduced due to inflation.
Business risk is probably one of the best known types of risk and is pretty straight forward. It is the risk that something unfavorable may happen to a company and cause your shares in the company to lose value. These risks include things like a disappointing earnings report, changes in personnel, or bankruptcy. Business risk can be a major risk for those who invest in only a few companies, or invest in many similar companies, as businesses within the same industry tend to be subject to the same types of risk. Diversifying your investments is one way to try and avoid business risk, although there’s no guarantee that a diversified portfolio will enhance overall returns, outperform a non-diversified portfolio, or protect against market risk.
Essentially, liquidity is the ready availability of money when one needs it. Liquidity risk is the risk an investor faces when their asset or investment cannot be converted into cash as quickly as they need it to be. This could either be due to the investment not being able to be sold or be prematurely terminated, or because the loss in value from selling would be infeasibly high. Real estate is a good example of an investment with high liquidity risk.
This type of risk applies to bonds in particular. It is the risk a bondholder faces when their bond comes due or is being called. It can be difficult to find a new bond that provides the same or greater interest rate than the old bond, which can leave the bondholder settling for securities that provide a lower level of income or buying bonds with lower credit ratings. This risk can be avoided if the bondholder plans on spending the interest payments or principal at maturity.
Knowing the types of risks associated with different investments is key to investing with confidence. While you can never eliminate risk, and no strategy can assure success or protect against loss, knowing what steps to take to manage those risks will put you on the right track to meet your financial goals.
As financial advisors, we specialize in helping our clients navigate these risks through asset allocation, diversification, and our years of expertise. If you’re worried about the risks your investments face, we encourage you to give us a call.