Risk
What is investment risk?
Every investment has risks. Risk essentially means the possibility of losing some or all of the money you have invested. You can never be sure what money will be made on an investment. One way to think about risk is to ask yourself whether you can afford to lose a percentage of an investment. See Diversified portfolio for an explanation of how to manage risk in an investment portfolio so that you manage risk to your advantage.
Risk is different when investing in a stock
or bond than in speculating by investing in hedge funds or forex, for example. There is the risk of doing nothing and leaving your money in a low-interest savings account and not making enough over time to meet your goals.
What is risk tolerance?
Your risk tolerance is your willingness to accept a level of risk in order to achieve a given return. Risk tolerance is different for each person. Identifying which investment products are more risky than others is an important piece of work you and your advisor must do to make sure investments are within your risk tolerance. See High-risk investments.
Investors take risks to earn dividends, interest, and capital gains to increase the value of their assets over the short and long term.
Types of investment risk
There are two main types of investment risk: market risk and company-specific risk.
Market risk relates to factors that affect the economy or securities markets. Market risks affect all companies’ stock regardless of the companies’ financial condition, management, or capital structure. It can involve international and domestic factors.
The most common market risks are:
- Interest rate risk: the risk that the interest rate reflected in an investment's value changes; therefore changing the value of the investment
- Inflation risk: the risk that prices of goods and services increase, therefore reducing purchasing power. Inflation risk and interest rate risk are closely tied because interest rates usually increase with inflation
- Currency risk: the risk that the value of one currency changes against the value of another. If you need to convert from one currency to another to make an investment, or if a company you have invested in has operations or investments in multiple countries with different currencies, any change in the conversion rate between those currencies can increase or reduce investment returns. See Forex.
- Liquidity risk: the the risk that you are unable to buy or sell investments quickly for a price that is close to the underlying value of the asset
Company-specific risks are risks that are associated with how a company is run, its operations. Common company-specific risks include:
- Management risk: this is the risk that inexperienced or unethical management team members or simply bad management decisions can affect a company’s performance
- Credit risk: the risk that a borrower, such as a bond issuer, doesn’t pay interest as scheduled or repay the principle at maturity
Two other types of investment risks are:
- Socio-political risk: the risk that social unrest or political decisions will affect investment markets. Some examples: terrorist attacks, war, pandemics, changes in tax policy or expropriation of assets
- Systemic risk: the risk that an entire market (or system) will crash