What's the tricky thing about investment risk?
No matter how you invest your money, you're taking some form of risk. And there's not just one or two investment risks - there's multiple types of risks to consider.
No single investment protects against all types of risk, either. Often when you protect against one form of risk, it exposes you to another.
So the more you know about how the various types of investment risk work, the better you can protect yourself.
Read on to learn how to recognize investing risks, how to decide which are most important to your situation, and how to balance protection against different risks.
What is Investment Risk?
"Risk" is defined as "exposure to the chance of injury or loss."
"Investment risk" describes exposure to the chance of loss in terms of how big the deviation is between an investment's expected return and its actual return.
Technically, the deviation from the expected outcome can be positive or negative, but most investors are concerned with the negative side - specifically, the high degree of risk that could result in loss of capital.
How investment risk works
Often people associate investment risk with the ups and downs of the stock market. But suppose you kept your money in a fireproof, theft-proof vault for ten years. Surely that would keep it safe from risk, right?
Ten years later, you might find you could buy much less with that money due to inflation than when it went into the vault.
Also, in ten years, that money would have made no progress toward growing to meet your future needs. You would have saved your money, but you also lost valuable time.
Those are just some examples of how risk takes on different forms. Risk includes anything that threatens to prevent you from reaching your financial goals, and that could be several things.
You can think of risk as a master of disguise. The key is to recognize it in all its disguises so you can deal with it.
Types of Investment Risk
Understanding these 12 types of investment risk can help you recognize and manage risks more carefully, so you reach your intended financial goals.
Capital risk is the risk of losing money, and it's usually what first comes to mind for most people when they think about investing risks. It especially refers to permanent losses that you don't have a chance to regain.
Naturally, all types of investors are averse to permanent losses. They only take capital risk if it is balanced against the potential for gains.
"Volatility" refers to the ups and downs that naturally happen to market-traded securities. The more extreme these ups and downs are, the more volatility risk you have.
Volatility differs from capital risk in that the downswings are not necessarily permanent. You have a chance to come back from them, but that can take time.
If you have near-term needs, you are especially sensitive to volatility risk. You can't afford a downswing just when you need your money.
On the other hand, if you have long-term needs, you will be better able to wait out the ups and downs of the market.
Credit risk (default risk)
This risk generally applies to bonds and other forms of debt securities.
Credit risk (or default risk) is the risk that the issuer of the security will not be able to meet its payment obligations.
At the most extreme, this could result in a permanent loss from not getting paid the principal you are owed on a bond.
However, even a partial default on interest payments is damaging because it robs you of some of the return you expected to get on the bond. Plus, any degree of default is likely to hurt the bond's price.
Horizon risk (duration risk)
Another risk that typically applies to bonds and other fixed-income securities is horizon risk. It stems from the length of time before your securities mature.
Horizon risk (or duration risk) comes in two forms:
- The longer away the maturity date of a bond is, the more its price could swing up and down in response to interest rate changes and other economic developments.
- If you own long-term securities but have short-term spending needs, there is a chance that your security prices might be down when you need to draw on the portfolio.
To some degree, there should be a match between when your securities come due and when your needs will occur.
Regulatory risk / political risk
Many industries are affected by government regulation on things like environmental rules for oil and gas drillers or patent enforcement for drug companies.
Changes to the law that impact an industry also change the business outlook for companies in that industry, and thus could affect the stock prices of those companies.
Political trends can change the regulatory environment for different industries as well. More broadly, political movements in society can affect stocks via boycotts and divestment campaigns.
Investors should be especially aware when investing in companies with controversial practices that regulatory and political forces could work against them.
Each security is subject to a specific set of risks. The more your portfolio is concentrated in any one security, the more exposed you are to the specific risks of that security.
To put it simply, if a company goes out of business and 2% of your portfolio was in that company's stock, it's a small setback. On the other hand, if 50% of your portfolio was in that company's stock, it's more like a big disaster hit your portfolio.
Limiting the amount of your portfolio that is in any one security reduces concentration risk.
Even if you reduce your exposure to any one security, you'll still experience the ups and downs that markets go through as a whole.
For example, if you own 50 different stocks, your portfolio is still likely to be down in a bear market. Only owning securities that participate in different types of markets can reduce your exposure to market risk.
Interest rate risk
Interest rates change almost daily, and this can pose a risk to your investments.
This can hurt you in either of two ways:
- Bond prices tend to rise when interest rates go down, and they fall when interest rates rise. So, rising interest rates represent a risk to bonds.
- Interest rate changes can mean earning lower interest rates on your investments. This form of interest rate risk can be thought of as reinvestment rate risk because the more often you have to reinvest your income securities, the more often you'll be subject to a potential reduction in your interest rate.
Seemingly safe securities like savings accounts and money market accounts are subject to interest rate changes at any time, so they are very exposed to reinvestment risk.
Typically, long-term investors should worry more about the reinvestment aspect of interest rate risk and so should invest in longer term fixed-income securities. Short-term investors should worry more about the volatility aspect and so should invest in shorter term securities.
Liquidity risk occurs when there is a mismatch between when money becomes available and when it is needed.
It is something that can cause cash-flow problems for businesses, but it can also happen to individual investors. If you have money tied up in a five-year CD but need to tap into that money in one year, you have a liquidity problem.
Choose your investments with an eye toward making sure money from them will be available when you need it.
This is the risk that your money will lose purchasing power over time due to rising prices.
Fifty years ago, something that used to cost $1 would cost $6.63 today. So, any investing for the long term should take into account the impact of rising prices.
Foreign investment risk / currency risk
Foreign countries are subject to different economic developments than the United States. In addition to the prices of their securities going up and down, their currencies may rise and fall relative to the value of the U.S. dollar.
This makes foreign investments subject to an additional source of potential risk. On the other hand, those investments can be used to diversify away from risks to the U.S. economy and markets.
When it comes to retirement planning, living longer than expected is a risk. It means having to fund more years of expenses than you had planned on.
Don't simply assume an average lifespan when planning for retirement, because roughly half the population will outlive that average. Plan on funding a long life in retirement and you can reduce longevity risk.
Riskless Investments (e.g., FDIC-Insured Accounts)
People often talk about FDIC-insured bank accounts as being risk-free investments.
However, this is an over-simplification.
An FDIC-insured savings account might protect you against volatility and permanent loss, but it could still leave you open to inflation risk, interest rate risk and other risks.
What the above list demonstrates is that investment risk comes in many forms. As a result, no one investment is free of all forms of risk. That means most investors need a portfolio made up of different types of securities to protect against different types of risks that could end up in sub-par returns.
Manage Risks with a Diversified Portfolio
Diversification means spreading your investments among several different securities to reduce the harm that a setback in any one security could do.
There is more to this than owning a lot of securities, though.
For example, you could own dozens of tech stocks; but if there's a collapse in the tech sector (such as when the dot-com bubble burst), most or all of your portfolio could be at risk.
Don't think simply in terms of diversifying securities.
What you really need to do is diversify risks.
How to Build a Diversified Portfolio to Manage Risk
Ideally, your portfolio should be constructed of securities that are exposed to a variety of investment risks.
Diversify across asset classes
This starts by owning different asset classes. Different asset classes give you effective diversification because they tend to react differently to economic developments.
- Cash equivalents
- Foreign stocks
- Real estate and other investments
Diversify within asset classes
Then, within each asset class, you want to spread your risks out further.
- Within stocks, your portfolio should be in different sectors of the stock market, spread among things like tech stocks, finance stocks, manufacturing stocks, etc.
- With bonds, you might have different types of issuers. This could include some government securities, some high-grade corporate bonds and possibly some bonds from high-yield or foreign issuers.
Your Strategic Approach to Investing
Building a diversified portfolio to manage risk depends on two things:
- Owning securities that give you some protection against different forms of risk.
- Identifying which risks are the biggest threats to your goals so your portfolio can emphasize securities which protect against those risks.
Finding such a variety of securities is easier than it sounds. A variety of brokerage firms offer mutual funds and robo-advisor products that can help even a novice investor build a diversified portfolio quickly and efficiently.
That can help protect you against risk - in a range of different forms - and set you on a path toward growing your wealth and achieving your financial goals.