Investing always carries some risks. What are the most significant risks for individual investors, and what risks will you encounter when investing?
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.
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 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.
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.
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.
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!
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.
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.
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, 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:
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:
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:
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:
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.
Continue with the next lesson of our beginner-friendly guide “Basics Of Investing”.