Risk essentially means the possibility of losing some or all of the money you have invested. Risk levels differ for each asset class.
There is also risk in doing nothing and leaving your money in a low-interest savings account or an investment that pays little interest.
What is Risk Tolerance?
Your risk tolerance is your willingness to accept a level of risk in order to achieve a given return, and it is different for each person. Identifying which investment products are more risky than others is an important piece of work that you and your registered investment advisor must do to make sure investments are within your risk tolerance.
Investors take risks to earn dividends, interest, or capital gains to increase the value of their assets over time.
Types of Investment Risk
There are two types of risk: market risk and company-specific risk.
Market risk relates to factors that affect the economy or markets where stocks, bonds, and other securities are traded. Market risk affects all companies’ stock regardless of financial condition, management, or capital structure. The most common types of market risk are:
- Interest Rate Risk – The interest rate reflected in an investment’s value changes, thus changing the value of the investment.
- Inflation Risk – Prices of goods and services increase, therefore reducing purchasing power of the money you earn on the investment over time. Inflation risk and interest rate risk are closely tied because interest rates usually increase with inflation.
- Currency Risk – 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, any change in the conversion rate between those currencies can increase or reduce investment returns.
- Liquidity Risk – You are unable to buy or sell investments quickly for a price that is close to the underlying value of the asset.
- Socio-Political Risk – Social unrest or political decisions will affect investment markets. Some examples: terrorist attacks, war, changes in tax policy or expropriation of assets, etc.
- Systemic Risk – An entire market (or system) will crash.
Company-specific risk relates to the operations, management, or financial condition of a company, which can change. Common company-specific risks include:
- Management Risk – Inexperienced or unethical management team members, or simply, bad management decisions can affect a company’s performance.
- Credit Risk – A borrower, such as a bond issuer, doesn’t pay interest as scheduled or repay the principle at maturity.
See our Diversification page for an explanation of how to manage risk in an investment portfolio.