The Basics of Investing - What are the different types of risk?
The Basics of Investing - What are the different types of risk
You can’t get away from the fact that all investing involves a degree of risk.
The value of your investments can go down as well as up and you may get less back than you invested. In some cases, you could even lose your entire stake.
Risk is often confused with volatility, but they are in fact two different things.
Equities in particular are subject to periods of volatility which can be very extreme. High volatility might keep you awake at night but it shouldn’t be mistaken for risk.
An example of a major risk is not having enough money to last your lifespan, or to fund a specific goal.
A common type of investment risk is concentration risk — the risk, if you like, that you have too many eggs in the same basket.
There’s also credit risk — the danger that a corporation, or even a government, will default on a bond.
Then there’s liquidity risk — the possibility that you aren’t able to realise cash from your investment when you need to. This can be a real concern for those who invest directly in property.
Some risks are more avoidable than others. For example, you can avoid concentration risk by having a diversified portfolio.
But one type of risk that you can’t diversify away is market risk, also called “systematic risk”.
Market risk is the possibility that you’ll experience losses as a result of factors that affect the overall performance of the financial markets.
Examples would be a major natural disaster, a terrorist attack or an unexpected rise in interest rates. Economic recessions can have a very detrimental effect on share prices.
In general, markets reward investors for market risk. The more risk you take, the greater the potential reward you can expect in the long term.
In practice, though, accepting market risk is far harder than it sounds.
Although they can expect to be compensated with high returns in the long term, those who stay invested when market risks are on the rise will have to endure market fluctuations that can test the resolve of even the calmest investor.
That’s why investors have to think very carefully about their need, their willingness and their ability to take risk. In many cases they will need to compromise.
Finally, you should always bear in mind inflation risk. This is the extent to which inflation will erode the real value of your investments and, hence, your future spending power. So, for instance, not investing enough is a risk — and so is having an investment strategy that is too cautious. Yes, that’s right, not taking enough risk is itself a risk.