Investment Risk: What You Need to Know
Posted by Frank Gogol
A lot of people are worried when it comes to equity investments because they have high risk, particularly since the risk has increased recently. But what exactly is investment risk and how do you define this risk based on the objective of your investment?
If you are an investor and want to make sure you do not deal with negative return experiences in the future, you must learn what investment risk is. In this article, you will be able to learn more about it, the different types of investment risk, and more.
Table of Contents
What Is Investment Risk?
Investment risk refers to the possibility of an investment’s outcome being unexpected. Simply put, it means that the actual gains you get from the investment might be different from what you expected to happen. It may also include the chances of losing the original investment either partially or fully.
So, it measures the uncertainty level when it comes to the returns you get out of an investment. It is very important to assess the risk of an investment. For the most part, investors are looking at lower risk as more favorable, and it makes them more willing to make an investment.
The lower the investment risk is, the more lucrative the investment can be. At the same time, investments with higher risk bring better returns, which gives investors conflicting feelings.
One can assess investment risk by looking at the historical outcomes and behaviors. Standard deviation is usually associated with risk in finance. It allows someone to measure an asset price’s volatility when compared to the historical averages in a specific time frame.
Once you understand investment risks and how they work, you can manage them more easily. Also, when you learn the risks that can apply in certain situations and the ways you can manage them, you will be able to prevent pricey losses as a business manager or investor.
Investment Risk Overview
Every single day, people are exposed to different types of risks, whether it’s from walking alone in dark, quiet areas, driving, investing, or anything else. So, when it comes to investors, they are definitely not an exception to the rule. The age, lifestyle, and personality of an investor are things you should always consider for purposes related to investment risk and management.
In fact, there are unique risk profiles for every investor, which shows not only their ability to withstand risk but also their willingness to do so. When investment risks are higher, investors expect higher returns as compensation.
The relationship between risk and return is a very discussed idea in finance, because the higher the risk an investor takes, the higher the return may be. Meanwhile, when an investment has lower risk, the potential return is lower as well. This is why investors need to be compensated for being willing to take on more risk.
Usually, investors assess risk by looking at the historical behaviors and outcomes, and they use standard deviation in order to measure risk. Companies, people, and financial advisors are all able to develop different risk management strategies so they can deal with the risks related to their business activities and investments.
Some of the metrics, strategies, and theories used to measure, analyze and manage risks include bets, standard deviation, the Capital Asset Pricing Model, and the Value at Risk.
Types of Investment Risk
There are different types of investment risks. The main ones are systematic risks and unsystematic risks. Investors usually have to deal with both.
Systematic risks are also known as market risks, and they tend to have an effect on the entire economic market or at least a large percentage of it. This type of risk represents the risk of losing investments because of factors like macroeconomic risk and political risk, which usually have a negative effect on the market’s performance. It is not easy to manage market risk by using portfolio diversification.
Apart from this type of risk, systematic risks also include currency risk, inflation risk, country risk, rate risk, liquidity risk, and sociopolitical risk.
Then, unsystematic risks are also known as idiosyncratic risks or specific risks, and they only have an effect on a certain company or an industry. It represents the risk of losing an investment due to any hazard specific to the industry or the company.
Some situations like this could be a product recall, a new competitor, or a management change. Diversification is often used to combat this.
Other types of investment risks apart from these include business risk, country risk, foreign-exchange risk, counterparty risk, political risk, interest rate risk, liquidity risk, and default or credit risk
Understanding Investment Risk vs. Reward
Investment risk vs. reward represents the balance between wanting the highest return you can get with the lowest risk possible.
Low-risk levels are usually considered investments that bring low potential returns. So, every investor has to decide how much risk they can handle in order to get the return they want. This can be influenced by different factors such as liquidity needs, personality, income, age, investment goals, and time horizon.
Now, you should know that just because you are willing to take more risk, it doesn’t guarantee a high return. Meanwhile, for lower-risk levels, you can take the risk-free rate of return, which is a theoretical return rate of an investment with no risk. It shows you the interest you can expect when you make an investment that has no risk for a certain period. It is the minimum you can get from any investment.
Investment Risk Diversification
Minimizing risk is possible, and the most common way to do so is by using diversification. In essence, diversification is based on the risk and correlation concepts. Usually, there will be a lot of different securities in a diversified portfolio, securities that come from various industries with different risk degrees, as well as correlation with the returns of the other.
Even though according to most investment professionals it is not necessarily set in stone that you will prevent a loss through diversification, it can still help investors a lot. It will help investors reach multiple financial goals and lower down the risk at the same time.
Planning diversification is possible by doing the following things:
- Maintaining diversity within every single investment type. You can include securities that are unique in their own way based on region, industry, market capitalization, and sector. On top of that, you can combine styles, like value, income, and growth. You should also consider varying credit qualities and maturities when it comes to bonds.
- Spreading your own portfolio among multiple investment vehicles, such as ETFs, mutual funds, bonds, stocks, and cash. Ideally, you should consider assets with returns that have not gone in the same direction historically, nor moved as much. By doing so, you will ensure that a part of your portfolio is still growing, even if the other is declining.
- Including securities with varying risk levels. You don’t have to choose blue-chip stocks alone – it is always better to choose different investments that come with varying rates of return. This will bring you larger gains rather than losses.
It is important to bear in mind that you have to keep going with portfolio diversification. It is not something you only do once and call it a day.
The Bottom Line
Investment risk is something that every investor needs to consider. Think about how much risk you face based on your portfolio, and never accept more risk than you are comfortable taking.