Investment risk doesn’t apply to only a select few investments, it applies to everything because every investment has its own sets of risk.
Do you know what they are? Are there ways to avoid them, or at least limit how they affect you?
Let’s dive deep into this topic and learn more.
What is investment risk?
I suppose in its simplest form, investment risk is the chance that your investment will lose value.
If you have a stock or a bond, your investment could lose value. If you have cash, inflation could eat away at your purchasing power.
There are many other types of investment risk.
Types of investment risk
- Interest rate risk – The chance that an increase or decrease in interest rates could affect your investment. This specifically pertains to fixed income investments, like bonds. Interest rates and price are inversely correlated, so if rates go up prices go down, and vice versa.
- Business risk – This involves a particular security. If you are investing in a company’s stock, the chance of them going out of business and you losing some or all of your investment is the risk.
- Industry risk – As you can imagine, this relates to an investment within a particular industry. There are industries that are affected as a whole by certain events. If oil prices drop, the energy industry will suffer. If the economy is booming, the consumer staples sector will underperform. If tariffs are levied on steel and aluminum, the automotive and industrials sectors will be negatively affected.
- Credit risk – This relates to a debt issuers ability to make good on their obligations. If you invest in a bond that matures in 10 years, you are supposed to receive two payments per year, plus your principal in the tenth year. The chance that, that debt issuer can’t make those interest payments or pay you back the principal is credit risk. I should mention that there is also a risk to stock investors. When a company goes bankrupt, it has to pay back lenders, investors, and others, but there is an order to which people are paid back, and stockholders are last on that list.
- Taxability risk – This refers to a municipal bond. If a muni bond is issued with tax-exempt status, the risk is that it could lose that status before maturity.
- Call risk – The chance that an investment is called back. A callable bond is the most common example. More often than not, a company will issue and call back a bond if interest rates have lowered. The issuer is refinancing in a sense. They buy the bonds back in order to reissue them at a lower interest rate, and this will cost them less money in the long run. Fear not, however, because you have the added risk of your investment being called away, you are usually compensated with a higher interest rate.
- Inflation risk – Essentially, how severely inflation could eat away at the purchasing power of your investment. Cash is most at risk because you are getting zero return and inflation at any level is costing you money. Stocks, historically, are the best investment to outpace inflation.
- Liquidity risk – Your ability to sell your investment when you want to. Some investments trade more frequently, thus have higher liquidity. Stocks are a great example of an investment with high liquidity. An investment with low liquidity, depending on the market environment, is real estate, or physical items, such as precious metals, guns, or art.
- Market risk – The risk that at any point in time your particular investment, whether it’s stocks, bonds, real estate, gold, etc. will lose value. Prices in all of those investments can and will fall at one point or another, and no amount of diversification can save you from it.
- Geopolitical risk – Think war, terrorist acts, tariffs being levied on certain countries or products, etc. Geopolitical risk happens in your country or in other countries that yours is involved with. When 9/11 occurred, the NYSE and NASDAQ closed in anticipation of panic selling. On the first day of trading, the Dow fell 7.1% and closed the week down 14% (source). Heck, just this year the threat of tariffs has put investors on edge and increased volatility.
- Currency risk – This usually affects people who have investments or business operations in other countries. If the value of a currency compared to the USD (U.S. Dollar) goes up, that could negatively affect the bottom line for businesses.
- Mortality risk – The chance that you will die before fees, premiums, and payments will have been worth it. This usually revolves around insurance products, but could also relate to social security or money you’ve stashed away for retirement through the years. If you worked and saved for 30 years, but passed away in your sixties, and were unable to enjoy the fruits of your labor, that’s mortality risk.
Three asset classes and associated risks
There are many other asset classes and investments available, but these are the three that most people are associated with.
- Stocks – Market risk, business risk, industry risk, credit risk, geopolitical risk.
- Bonds – Market risk, business risk, industry risk, credit risk, geopolitical risk, inflation risk, interest rate risk.
- Cash – Inflation risk
Though not all risk can be diversified away, and you will take on some risk in every investment, no matter how careful you are, it’s important to diversify.
Each asset class and each investment have its own unique risks. In any portfolio, it’s important to diversify between stocks, bonds, real estate, cash, physical assets, and geographic location.
The allocation to each set of assets will vary depending on your risk tolerance. Traditionally, stocks are the riskiest of these but offer the most reward, then bonds, and then cash. Holding real estate and physical assets, like gold is just another way to diversify your assets. Gold, however, is usually a good investment to have when the market tanks, as it’s often referred to as a safe haven asset.
With regard to geographic location, the U.S. is only one-quarter of global GDP (source) and the U.S. stock market is only 43% of global market value (source) so you’d be silly not to invest money in other countries. Besides, if the U.S. market/economy tanks, not every country will follow.
Read more about diversification, here.
Investment risk is unavoidable, and depending on what type of asset you own, you may have more or less risk. The one thing you can do to help protect yourself it to diversify.
To learn more about investment risk, diversification, and our disclosures, visit www.crgfinancialservices.com.
Diversification seeks to reduce the volatility of a portfolio by investing in a variety of asset classes. Neither asset allocation nor diversification guarantee against market loss or greater or more consistent returns
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