🏛 Basics Of Investing

Risk In Investing

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Is Investing Risky? A Beginners Guide To Risk In Investing

Investing always carries some risks. Learn about the biggest risks for individual investors and the types of risks you might encounter when you invest.

There is a common saying on Wall Street 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.

Investing is risky, 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. Investment risk is one of the most fundamental concepts to understand the basics of investing.

🧭 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. As a result, 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.

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What Is Risk In Investing?

In investing, what is considered risky depends on who you ask and your personal risk tolerance. For now, we will take a 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.

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.
  • High price volatility of investments.

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 depends on its asset class. 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.

Price volatility is measured 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. We won't dive deeper into standard deviation here but if you like to learn more you can check out this guide by Investing Answers about standard deviation.

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, even a profit might be seen as a risk if it cannot outpace inflation or taxes. In this case, the net result after taxes and inflation can still result in a loss.

These losses can represent a significant setback when meeting their 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 a loss, seeing a loss for your investments might lead to short-term thinking and irrational decision. One of the most important lessons in investing is to always avoid making emotional decisions in these cases.

Rather than panic-selling your losing investment, 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. As a result, the underperformance of their fund is seen as a risk by many mutual fund managers.

If the fund performs worse than other funds, it will likely lose assets as customers liquidate their holdings. As a consequence, the managers themselves will likely lose their job. This leads to mutual funds trying to match each other's performance and therefore only average performance can be expected from mutual funds as a whole.

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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 return. If investors weren't able to make a higher return when taking higher risk there would be no incentive.

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!

đź’ˇ Example

Let's take a look at stocks for example. Investors invest in stocks because they expect the company to become more valuable in the future or to receive dividends from the company. However, investments are always based on assumptions. There is no guarantee that they will come true in the future. Therefore a greater uncertainty must be rewarded with greater potential returns. Otherwise, there would be no point to take the higher risk.

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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.

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.

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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 risk and unsystematic risk. 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 investment 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.

Unsystematic Risks

Risks that are specific to your individual investment are called unsystematic risks. For example, these can be a deteriorating business or the risk of a company's default.

Common unsystematic risks are:

  • Business risk: Business risk in investing is concerned with all expenses a business must cover to remain operational and functioning, such as salaries, production costs, office or administrative expenses. It involves the risk that the company might not be able to cover these essential expenses in the future.
  • 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: Some investments, like stocks, carry the risk that the underlying entity might have an insufficient cash flow to pay for its obligations. This may result in the non-payment of debts owed by the entity.
  • Credit risk and default risk: Credit risk is similar to liquidity risk and can directly result from liquidity risk. 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 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.

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