Different Types of Risk in Investment for Beginners
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As with anything in life, a journey to gain something is a journey to risk another, and so are investments. Any investment will have a certain level of risk whereby there are uncertainties that could result in losses — but as treasures were made for the braves, higher risks are known to bring forth higher wages.
Fortune does favor the bold, but being bold and being careless are two different things. Find out about all the risks there are to investments so that you may conquer them and bring back some gold!
What is risk in investment?
Risk in the context of investment refers to the potential that you can suffer (financial) harm and losses from your investment decisions. There are many ways in which risks are managed, and there are also methods that have been used in trying to quantify risk nowadays.
Usually, historical data, as well as currently available data are churned together using a few statistical methods so that investors or financial advisors can get a proper grasp of the risk surrounding a particular investment. A few examples of risk indicators that are widely used are Beta, Sharpe Ratio, and Standard Deviation.
Different Types of Risk in Investment
Business risk refers to the risk of a business failing — big, small, magnanimous — any form of business failure will definitely affect your portfolio. That is why it is important for you to know the company you’re putting your money in. It’s vital to know its corporate governance practices, its balance sheets, and the management team of the company.
This is something that goes without saying, but this is also the bane of many investors. Your asset price will move up and down. Stocks, bonds, funds — you name it!
Fluctuation to investment is like water to humans. Too little of it and you’ll be out for a draught, too much and you’ll drown, have it just nice and you’ll be looking at a healthy investment portfolio. The most common way that people look into volatility risk is through Beta values.
TLDR; don’t avoid fluctuations, manage them according to your risk tolerance.
Unlike systematic risk which affects almost every single asset out there, unsystematic risk refers to the risk that if it happens, it will only affect a small number of assets, or specific assets — even.
For example, on January 24th, 2023, Hindenburg Research published a report claiming Adani Group companies to have been involved in stock manipulation and accounting fraud. This in return, wiped out almost 60% of the company’s value.
Keep yourself abreast of current issues affecting your assets, but there’s only so much one can do — sometimes these details slip through your fingers — but don’t beat yourself on it, learn and keep walking.
Default risk refers to the risk when one can’t pay their debt, and you are standing on the debtee’s side (one who lends out the money). This usually happens in the investment of bonds and debentures, but there is a risk-level system assigned to bonds whereby the lower the rating is for a bond, the higher the likeliness is for default.
Choose one that suits your risk tolerance. Of course, higher risk equals higher returns. Just know that if you go for something that is too risky, the same money can be used at a poker table.
Find out the risk level here: Investing in Bonds for Beginners
Forex or currency risk refers to the risk that comes when there are movements in the currency value of a country. Say, you invest in an American Company, Company ABC that operates in China, and all the revenues it made are from the Chinese market and in the Chinese Yuan.
Say, you invested in 2013, where $1 USD = 6 CNY (we made up the numbers). So, if the company makes 6 billion CNY, that’s $1 billion USD in revenue for Company ABC.
Suddenly, China’s currency falls to $1 USD = 7 CNY. Now, if the company makes 6 billion CNY, there are only around $857,142,857.14 USD for the company — that’s a reduction of $ 142,857,142.86.
Inflation risk refers to the risk that occurs due to inflation. Inflation is a state where the value of goods goes up — or you could also say that the value of your money weakens.
If inflation goes up, the value you can get from your investment would go down.
Imagine you invested for a month, put in $1,000, and made $1,050. You just gained $50! At that moment, the rate of inflation was quite low so with that $50, you get to go out and buy 3 days’ worth of groceries.
You then kept that $1,000 for another month in your investment account and you managed to make another $50! However, at this point, inflation was excruciatingly high, and with that $50 you only get to buy a day’s worth of groceries.
Inflation can eat up your profit without you realizing it. Always keep yourselves informed on the actual profit you’re making from your investment.
7. Interest rate
The interest rate here refers to the interest rate set by central banks. This interest rate is usually moved up and down for them to somewhat steer the market in a direction they deem desirable. The interest rate often goes up and down, and its direction will affect how your investment may look like.
Usually, fixed-rate investments such as bonds and guaranteed investment certificates are the most susceptible to interest rates. Take Silicon Valley Bank’s (SVB) failure as an example, whereby they invested hugely into bonds.
From 2022 to 2023 the Feds consistently raises interest rates in the U.S. to curb inflation. It came to a point where the value of bonds dropped so sharply that SVB had to sell its bonds at a $1.8 billion loss.
This refers to the risk that comes from how easily you can buy or sell an asset. For example, you see that Stock ABC has a high potential, but you need to buy it as soon as possible to get the best price. However, if Stock ABC is illiquid, you’ll find it hard to buy since there are not many sellers willing to sell you the Stock at the price you asked for. In the end, you might have to compromise and offer to buy it at a higher price.
The same way goes for selling liquidity. If you want to sell your shares, it doesn’t always mean that you can secure the deal. Sometimes when the stocks are illiquid there are little to no buyers, so you’ll have to sacrifice some of your profits by offering a lower price.
Mortgage here refers to the risk that may happen when there’s a failure for a party in a mortgage to pay their mortgage obligations in accordance with the terms of the mortgage. Mortgages are calculated, ‘packeted’, and sold at the financial market.
So, even if the party pays the mortgage (but a bit late), it will disturb your investment calculations. Imagine investing $1,000 for a year just to get $1 out of it. Might as well go and sell corndogs at a baseball match. One day could earn you more — at least the sweats are worth more than $1.
This risk isn’t actually bad, but it will make you curse. It refers to when you have already decided and acted on an investment that you can’t go back on, and then there’s a new-and-better opportunity that suddenly appears. Isn’t it curse-inducing?
Political risk is where any political events may affect your investment. For example, some stocks in the United Kingdom (U.K.)’s market take quite a hit when the government decided to go for Brexit. When Russia invaded Ukraine, the shockwave rattled the economy that many companies are looking at trampled supply chains and huge losses.
Country risk refers to a risk that a country might default on its debt obligations. It’s quite uncommon, but it’s not impossible. Sri Lanka, for example, defaulted on its overseas debt in May 2022. Be sure to keep yourself aware of the economic health of the country you’re investing in.
Counterparty risk refers to the risk that a party in the whole of transactions in your investment might default and affect your investment. For example, you invest in Company ABC, which invests a lot in corporate bonds — one of which is a bond from Company XYZ.
Apparently, Company XYZ defaulted on its bonds, which affects Company ABC’s revenue. Now, your investment will also be affected since XYZ’s default affect ABC’s revenue.
Managing Risk in Investment
Embrace risk but be smart.
There are no ways that you can avoid risk. There will always be risks in life, regardless of how small it is. The only way that you can avoid any risk from investing is by not investing at all, but it comes at the risk of you might not be able to generate as much income as you have if you’ve invested.
The key is not to avoid risk and embrace it but be smart while doing it. Know how much risk you can afford — make sure that you can at least survive if you lose money while you invest.
There are many ways to manage risk, but one of the most used methods to manage risk in your portfolio is diversification. It is a way to ensure that the amount of risk summed up in your portfolio is manageable, and makes you less vulnerable to any bad news in the market.
Want to diversify your portfolio? We wrote something just for you! Check out our writings: How To Diversify Your Portfolio.
- Investing always comes with some level of risk, whether you’re investing in stocks, bonds, real estate, or any other type of asset.
- Understanding the risks involved can help you make more informed investment decisions, as you’ll be able to weigh the potential rewards against the potential downsides.
- Failing to understand the risks involved could lead you to make unwise investments that could end up costing you a lot of money.
- Different types of investments come with different types of risks. For example, stocks are generally considered riskier than bonds, but they also offer the potential for higher returns.
- Some specific risks to be aware of when investing include market risk (the risk that the entire market will decline), default (the risk that a borrower will default on a loan), and liquidity risk (the risk that you won’t be able to sell an investment when you want to).
- It’s important to have a diversified investment portfolio in order to help mitigate risk. This means investing in a variety of different assets to spread your risk.
- Investing always involves some degree of uncertainty, and there’s no way to completely eliminate risk. However, by understanding the risks involved and taking steps to manage them, you can increase your chances of achieving your investment goals over the long term.
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None of the material above or on our website is to be construed as a solicitation, recommendation or offer to buy or sell any security, financial product or instrument. Investors should carefully consider if the security and/or product is suitable for them in view of their entire investment portfolio. All investing involves risks, including the possible loss of money invested, and past performance does not guarantee future performance.