The word “risk” is interpreted differently by each and every one of us. When some people think of taking risks, they get excited and think of the possible benefits they might gain from making those risky decisions. For others, the idea of risk is completely frightening and they may try to reduce the inherent feelings of uncertainty that come along with taking risks. For many of us, our feelings about risk are mixed between these two poles – excitement and nervousness. That is why we try to take calculated risks – or decisions that may be just risky enough to match our own personal comfort levels. But, to do so, we need to fully understand all of the various kinds of risks that come along with making different investment decisions.
In finance, risk refers to “the degree of uncertainty and potential financial loss inherent in an investment decision.” From this, we understand that all investment decisions carry some form of risk. Why? Well, whenever you invest your money somewhere, you are putting that money on the line, with the hope of obtaining a payout that is more than what you put in. However, no investment decisions are guaranteed. The risk you take could be something like your ability to readily use your money if you needed it (as, with some investments, you don’t want to take your money out of the investment until a set time), the conditions of the market over time, or the demand for the companies or investments you choose. In any situation, your investments will carry some form of risk. Depending on your risk preferences and your understanding of the diverse kinds of risks that certain investments carry, you may consider different investments.
To make your study of risk a little simpler, we have compiled a list of some of the main forms of investment risks here:
1. Business Risk
When you purchase a stock, you are really purchasing ownership in a company. This means that you are counting on that company’s business to remain constant – and hopefully grow – while you own the stock. If a company goes bankrupt while you own its stock, your payout could be much less than you hope. So, you want to be sure to pick financially strong businesses that you believe will succeed for the duration of your ownership period in order to avoid business risk.
Of course, even companies that are financially strong will experience volatility at times. This means that their stock prices will fluctuate up or down. This can be caused by events such as the releases of new products, political events, or seasonal changes. For some investors, volatility may be unnerving. If you are an investor who does not like the idea of big price fluctuations, it may be a good idea to research a stock’s volatility history to get a better idea of how much that stock has changed in the past.
3. Liquidity Risk
As mentioned before, with certain investments, it is possible that investors may not be able to buy or sell securities when they want to. This can be based either on the lack of available markets for buying or selling, or simply on a penalty for early withdrawal that an investor agreed to when the initial investment was made. This kind of risk occurs frequently in markets such as real estate, where it might be difficult to sell a property at a moment’s notice, but less frequently in markets like the securities market.
4. Market Risk
This kind of risk affects an entire market – such as political or structural changes that may affect all investments. Because this risk is market-wide, it may be hard to avoid.
5. Inflation Risk
This risk is due to the chance that the value of an asset will decrease if the home country’s currency inflates. However, for many investors in the securities market, diversified portfolios can grow faster than the inflation rate, which protects investors from inflation risk.
6. Interest Rate Risk
This risk applies largely to the bond market. When an investor sells a bond, he or she will receive interest on the initial investment. However, depending on the interest rate at the time the bond is sold (and whether the bond was held until maturity), the investor could end up losing money on his original payment. This kind of risk can be mitigated by holding bonds until maturity or waiting to sell until interest rates are higher.
We hope that this introduction has helped you to get a better understanding of the types of risks you might face as an investor. While there are never guarantees in investing, you can certainly try to minimize the risks you take on by knowing your risk preferences and understanding how risk works!