Is Investing Risky? A Beginners Guide To Risk In Investing
Investing always carries some risks. What are the most significant risks for individual investors, and what risks will you encounter when investing?
In this chapter, weâll take a look at:
Wall Street has a common saying that there is no free lunch. Every investor must decide how much risk they are willing to take to achieve an expected return. Investors who are unwilling to take any risks will not make a profit. Because investing always carries varying degrees of risk, and you will lose money at times. This is why you must be aware of the different types of risks you might encounter as an investor.
đ§ Key Takeaways
- There is a direct relationship between investment returns and investment risk.
- You will achieve higher returns by taking bigger risks. Contrary, taking lower risks will result in lower returns.
- There is no such thing as a risk-free investment as it is not possible to make a positive return without taking risks.
- To most individual investors losing money due to taking risks is the biggest risk in investing.
What Is Risk In Investing?
In investing, what is considered risky depends on your personal risk tolerance and your financial goals. Therefore, every investor has their own definition of risk and how much they are willing to take. For now, we will look at investment risks from the perspective of academics, individuals, and mutual fund managers. Later we will also cover risks specific to investments rather than investing as a whole.
Overall, typical risks in investing are:
- The partial or total loss of investing capital.
- A loss relative to inflation and taxes.
- Not being able to meet financial goals and fund future needs.
- Underperforming other investors or funds.
- A high price volatility of different asset classes.
The Academic Perspective On Investment Risk
The academic view on investment risk is that the volatility of the price of an investment defines its riskiness. The volatility of an investment refers to how consistent investment returns can be made. High volatility means that you can expect erratic investment returns. Contrary, low volatility means that you will receive more consistent returns.
The volatility of an investment is linked to its [asset class](/post/asset classes). It can be measured in many different ways and over different timeframes. For example, you could measure volatility using price highs or lows or the closing prices of an investment.
One way to determine price volatility is using the standard deviation metric. It measures how much the return of an investment can vary from its average return. A higher standard deviation implies a higher volatility and, therefore, a higher risk from the perspective of academics. Contrary, a lower standard deviation means that the asset's prices are more stable and thus less risky.
Risk From The Perspective Of Individual Investors
While academics describe risk as volatility, most individual investors will not see volatility as the most significant risk in investing. To them, the biggest investment risk is the total or partial loss of invested capital. However, you must judge your investing success using your real return. The real return is your return minus the current inflation rate and taxes. A positive return might still turn into a loss if you didn't manage to outpace inflation or have to pay a high amount of taxes.
Any losses can represent a significant setback when trying to meet your financial goals. Every investor has long-term financial goals, like funding their retirement, which they aim to achieve using their investing strategy. Failing to meet these financial objectives and therefore not funding future needs can be seen as the most relevant risk for individual investors.
No matter how successfully you invested before your first loss, seeing a loss for your investments might lead to short-term thinking and irrational decisions. But you have to avoid making emotional decisions at all costs. Instead, try to base every investing decision, no matter if it's about buying or selling assets, on extensive research and facts.
Rather than panic-selling your losing investments, you should reevaluate your investment thesis. If it is still intact, a temporary loss might present an ideal buying opportunity. Otherwise, you should consider exiting the investment and instead invest in assets with better prospects.
Risk From The Perspective Of Fund Managers
Mutual funds often stand in direct competition with other similar funds. Their ability to find new clients is directly related to the ability of their fund managers to make good investment decisions and high returns. As a result, the underperformance of their fund is seen as a risk by many mutual fund managers, and it may lead to the fund's closure.
If the fund performs worse than comparable funds, it will likely lose assets as customers liquidate their holdings. As a consequence, the managers themselves will likely lose their job. Therefore, many mutual fund managers will not make the extra effort to aim for higher-risk investments with higher returns. Instead, they will try to match the performance of other competing mutual funds. This is a bad deal for their clients as they will only be able to expect average performance from most mutual funds.
What Is The Relationship Between Risk And Reward?
There is a direct relationship between the risk you take and the expected return on the investment. Every investor takes risks as they hope to make a positive return. If investors weren't able to make a higher return when taking higher risks there would be no incentive for them to invest in riskier assets.
Therefore, all else being equal, the price of an investment goes down if the risk goes up and vice versa. The closer the investment will come to achieving the expected profit, the higher the price will be.
Remember that it is not possible to make back a return from an investment without taking risks!
đĄ Example
Investors invest in stocks because they expect the company to become more valuable in the future or receive dividends from the company. However, your investments will always be based on assumptions about the future of the investment, and there is no guarantee that they will come true in the future. Therefore greater uncertainty must be rewarded with greater potential returns. Otherwise, there would be no point in taking the higher risk.
Do Risk-Free Investments Exist?
One of the lowest-risk investments you can make is to buy U.S. Treasury bills (T-bills). These are government-guaranteed debt obligations that mature within a year or less. Once they matured you will receive your purchase price plus interest back.
T-bills are often seen as riskless investments because of the short maturity and government guarantee. You can indeed earn a guaranteed return on them. However, this return is still subject to the adverse effects of inflation and taxes which present a risk for your investment.
An alternative to T-bills are Treasury Inflation-Protected Securities (TIPS) which protect you from inflation. However, TIPS are still subject to the effects of taxes. In addition, they are being traded on market exchanges and therefore have the additional risk of price fluctuations.
In the end, there is no such thing as a risk-free investment. However, some assets have so little risk that they are considered risk-free by many investors. As a result, compared to higher-risk investments, these lower-risk investments can be an excellent alternative for investors with a more conservative risk profile.
What Types Of Investment Risks Exist?
Previously you learned about investment risks from the perspective of individual investors, academics, and fund managers. However, there are also risks specific to individual investments.
Investment risks are commonly divided into systematic risks and unsystematic risks. When you make an investment you are exposed to both systematic and unsystematic risks.
Systematic Risks
Systematic risks, also known as market risks, affect the entire economy and are not specific to your investment. These may include political and economic risks as well as unexpected events.
The most common systematic risks are:
- Inflation risk: Inflation is an effect that causes prices to increase faster than the value of money. As a result, the purchasing power is being reduced. This presents a risk for investors as it can reduce returns due to the lower purchasing power.
- Interest rate risk: Interest rate risk happens when the absolute level of interest rates changes. In inflationary environments, interest rates may rise to reduce the effects of inflation. This makes risky investments less attractive as borrowing money becomes more expensive and returns are being reduced.
- Country risk: Country risk refers to the risk that a country won't be able to honor its financial commitments. When this happens it may impact the performance of all other financial instruments in that country. In addition, other countries that have relations with the defaulting country may be affected as well.
- Foreign exchange risk: When you make an investment in a foreign market exchange you are exposed to currency risk. It applies to all investments that you make in a currency other than your domestic currency. The risk comes from differences between your domestic and foreign currency. It may cause losses when selling your investment and converting your profit back into your domestic currency.
- Political risk: A significant systematic risk is the risk of political instability or changes in a country that worsen the investment environment. These political changes can result from a change in government, legislative bodies, foreign policies, or military intervention. Political risk is especially important to consider for investments with long time horizons.
- Event risk: Unexpected developments can severely impact your investments. One of the best examples is the COVID-19 pandemic which caused a market crash at the beginning of 2020. Other examples include the unexpected disruption of supply chains or manufacturing processes or political instability and unrest.
Unsystematic Risks
Risks that are specific to your individual investment are called unsystematic risks. Unlike systematic risks, unsystematic risks are only affecting a small set of assets, rather than the whole market.
Common unsystematic risks are:
- Business risk: Business risk is the risk that a company will not be able to cover essential expenses in the future. Essential expenses are all expenses a business must cover to remain operational and functioning, such as salaries, production costs, office or administrative expenses.
- Volatility risk: When you invest in an asset with volatile price fluctuations you expose yourself to volatility risk. The higher volatility results in both a higher potential for profits and losses. It can be a serious risk, especially when purchasing with a short-term mindset.
- Liquidity risk:Â Some investments, like stocks, carry the risk that the underlying entity might have an insufficient cash flow to pay for its obligations. As a result, the entity might be unable to pay back its debts. This may result in the non-payment of debts the entity owes and cause issues for your investment.
- Credit risk and default risk: Credit risk is similar to liquidity risk and can directly result from liquidity risk. However, while liquidity risk is seen from the perspective of an entity that borrowed money, credit and default risk are seen from the perspective of the entity that is lending it. It describes the risk of missing out on repayments on debt owned by an entity. Investments with a higher credit risk will usually have a higher potential return.
- Counterparty risk: Whenever an agreement is reached between two or more parties there is always a small risk that one side does not fulfill their part of the agreement. This risk is called counterparty risk.
- Event risk: Event risk can also apply to individual investments. A serious series of car crashes might, for example, impact the value of an investment in a car company. The same may go for unexpected production delays or the outcome of lawsuits against a company.
What Is Your Risk Tolerance?
Your risk tolerance is your ability and willingness to accept a decline in the value of your investments. When you define your own risk tolerance, you should ask yourself how comfortable you are with a loss of your investment, even if it is only temporary. In general, the higher your risk tolerance is, the higher your possible return or loss will be.
Your risk tolerance is typically divided into three different categories:
- If you have a conservative risk tolerance, you will settle for low returns on your investments in return for a low risk of achieving an investment loss. Typical investments for conservative investors are savings accounts, certificates of deposits, and low-risk government and municipal bonds.
- A moderate risk tolerance allows you to take higher but not extreme risks. Investors with a moderate risk tolerance will generally balance assets with different risk levels to achieve a good balance between risk and reward. A typical asset allocation for moderate investors consists of 60% stocks and 40% bonds, therefore striking a balance between growth and stability.
- Finally, investors with an aggressive risk tolerance will focus on riskier investments. While these investments have a higher chance of making a big profit, they also have a much higher chance of making a significant loss. Typical investments made by aggressive investors are stocks, real estate, and cryptocurrencies.
How Do You Determine Your Own Risk Tolerance?
You should define your risk tolerance based on your expected time horizon, your financial goals, and your ability to avoid emotional decisions when the market is down. Here are a few questions that you should ask yourself when you define your own risk tolerance:
- Do you need your money in the near future, or do you have a lot of time to ride out market downturns? Generally, the sooner you need your money back, the lower your risk tolerance should be.
- Do you want to grow your wealth, or do you already have a decent nest egg that you want to preserve? If you want to grow your money, you should aim for riskier investments than when you want to preserve the value of your existing money.
- Do you tend to make emotional decisions in times of crisis, or can you stay rational even if the future looks bleak? A higher risk tolerance requires you to make rational decisions when the value of your investments is going down. If you are the type of person who makes emotional decisions, you might hurt your own investment performance and miss out on good opportunities to purchase more assets at cheaper prices.
What Is The Difference Between Risk Tolerance And Risk Capacity?
However, your risk tolerance might be different from your risk capacity. While your risk tolerance describes your willingness to accept a loss, your risk capacity describes your ability to take risks. Ideally, both your risk tolerance and risk capacity should be aligned.
For example, you have a large risk capacity if you're young and just started to invest. You will invest for a long time, somewhere between 40-60 years, and therefore can stomach larger losses. Contrary, your risk capacity is lower when you are close to retirement and cannot afford to lose your retirement savings.
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Continue with the next lesson of our beginner-friendly guide âBasics Of Investingâ.