Types of Investment Risk
“High risk, high reward,” is something you may have heard in regards to investing — but what are those investment risks? How are they measured? And how can investors mitigate them?
Managing the tradeoff between risk and reward is at the center of most investment decisions, so to properly make this tradeoff it is useful to understand different types of investment risks and when they are relevant.
What is Investment Risk?
Risk is defined in financial terms as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment — also called the principal.
Risk is generally measured by considering historical behaviors and outcomes. In finance, standard deviation is a common metric associated with risk. Standard deviation provides a measure of the volatility of asset prices in comparison to their historical averages in a given time frame.
Overall, it might be possible to manage investing risks within your control by understanding the basics of types of risk and how they are measured.
Learning the risks that can apply to different situations and some of the ways to manage them holistically could help all investors, from accredited investors to day traders, avoid unnecessary losses.
Risk Profile & Time Horizon
In the financial world, risk of loss is present in practically every investment decision. The type and degree of risk will vary based on multiple factors, but two of them are an investor’s asset allocation and time horizon.
Each investor has a unique risk profile that determines their willingness and ability to tolerate risk. In general, as investment risks rise, investors want higher returns to compensate for taking those risks.
Your time horizon and liquidity are often key factors influencing risk assessment and risk management. If an investor needs funds to be easily accessible, they’re less likely to invest in illiquid assets.
Time horizon refers to the period of time an investor anticipates holding an investment. An investor’s time horizon will vary based on investment goal and age. Younger investors typically have longer time horizons and may be willing to invest in higher-risk investments with higher potential returns.
Liquidity needs refers to an investor’s capacity to quickly and easily convert all or a portion of their portfolio into cash without experiencing extreme loss. An investor who prefers to feel more easily able to pull money out of the market would have higher liquidity needs, and in turn, a lower risk tolerance.
Risk vs. Return
A fundamental idea in finance is the relationship between risk and return. “High risk high return” is a common mantra on Wall Street. This basically means the greater the amount of risk an investor is willing to take, the greater the potential return on their investment.
For example, a US Treasury bond is considered one of the safest investments and when compared to a corporate bond, provides a lower rate of return.
The risk-reward tradeoff is the balance between the desire for the lowest possible risk and the highest possible returns. Each investor must decide how much risk they are willing and able to accept for the desired return.
An individual’s risk tolerance will be based on factors such as age, income, investment goals, liquidity needs, time horizon and even personality.
It’s important to note that while there is a general tradeoff between risk and reward, higher risk doesn’t automatically guarantee higher returns. The tradeoff only indicates that higher risk investments have the potential of higher returns. There is still always the very real possibility of losing some or most of your principal investment.
Types of Investment Risk
There are risks associated with practically every saving and investment action. In general, financial theory classifies investment risks affecting asset values in two categories: systematic risk and unsystematic risk. Most investors are exposed to both.
Systematic risks, also known as market risks, are risks that can impact an entire economic market or a large percentage of the total market. Market risk is the risk of losing money due to factors that affect the performance of the overall market, also called volatility risk.
Market risk cannot easily be mitigated through portfolio diversification. Common types of systematic risk include interest rate risk, inflation risk, currency risk and sociopolitical risk.
Unsystematic risk, also called specific risk or idiosyncratic risk, is a category of risk that only impacts an industry or individual company. Unsystematic risk is the risk of losing an investment due to a company or industry-specific event.
Examples of unsystematic risk include a change in management, a product recall, regulatory changes or new competitors in the space. Investors often use diversification to manage unsystematic risk by investing across a variety of asset classes.
Business risk refers to the basic viability of a business: whether or not a company will be able to cover operational expenses and turn a profit. While financial risk is concerned with financing costs, business risk is concerned with all the other expenses a business must cover to remain operational.
These expenses include salaries, production costs, facility rent and administrative costs. The level of risk of a company’s business is normally influenced by factors such as costs of goods, profit margins, competition and the overall level of demand for its product or service.
Credit Risk or Default Risk
Credit risk is the risk that a bond issuer will be unable to pay the interest or principal. This type of risk is mainly concerning for investors who hold bonds in their portfolio.
Treasury bonds, and government bonds in general, have the least amount of default risk and, therefore, the lowest returns.
Corporate bonds, on the other hand, tend to have the highest amount of default risk, but also higher interest payments. Bonds with a lower chance of default are considered “investment grade,” while bonds with lower credit ratings are called “high yield” or “junk bonds.”
Investors can use bond rating agencies — S&P, Fitch and Moody’s — to determine the credit rating of companies, or how likely they are to default. However, these indices do not ensure a company will not default.
Country risk is the concern that a country won’t be able to honor its financial commitments. When a country defaults on its debts, it can harm the performance of all other financial instruments in that country, as well as other countries it has relations with.
Country risk applies to stocks, bonds, mutual funds, options, and futures that are issued within a foreign country. This type of risk is most often seen in emerging markets or countries that have a severe deficit.
Foreign Exchange Risk
When investing in securities issued by foreign countries, it’s important to consider the fact that currency exchange rates can change the price of those assets as well. Exchange rate risk applies to all financial instruments that are in a currency other than your domestic currency.
For example, if you live in the US and invest in a stock on the London Stock Exchange in British Pounds, even if the share value appreciates, you may lose money if the GBP depreciates in relation to the US dollar.
Interest Rate Risk
Interest rate risk refers to the chance that the value of your investment will change due to a change in interest rates, the spread between rates, the shape of the yield curve or any other interest rate relationship.
This type of risk impacts the value of bonds more directly than stocks, posing a significant risk to all bondholders. The price of fixed income securities is inversely correlated with interest rates, meaning if the Federal Reserve hikes interest rates, the market price of bonds will fall.
There is always a possibility that investment returns don’t keep up with the rate of inflation, causing a more significant loss in purchasing power for the investor. Inflation erodes the purchasing power of money over time, meaning the same dollar amount will buy fewer goods and services.
Inflation risk is particularly relevant for investors who own cash or bonds, investment vehicles most impacted by rising inflation.
Some investments are considered inflation hedges because they offer stable stores of wealth during inflation-based stock market volatility. Real estate, Contemporary Art, and precious metals are some examples of potential inflation hedges.
Political risk is the risk an investment’s returns could suffer because of political instability or changes in policy in a country. This kind of risk can stem from a change in political leadership, legislative bodies, foreign policy makers or military action.
Also referred to as geopolitical risk, this risk can become more of a factor as an investment’s time horizon gets longer as the potential for change is greater over the long term, especially in countries with political turmoil.
Liquidity risk is associated with an investor’s ability to sell their investment for cash. This risk applies most to investors who hold illiquid assets such as hard assets or private equity. Investment products sold on the open exchange do not have as much liquidity risk.
Typically, investors will require some premium for illiquid assets which compensates them for holding securities over time that cannot easily be liquidated.
Risk and Diversification
Individual investors, financial advisors, and companies can all develop risk management strategies to help manage risks associated with their investments and business activities.
In economic theory there are several metrics and strategies that have been identified to measure, analyze and manage risks. Some include: standard deviation, beta, Value at Risk (VaR) and the Capital Asset Pricing Model (CAPM).
The most basic strategy for minimizing investment risks is diversification. Diversification is based heavily on the concepts of correlation and risk.
A well-diversified portfolio tends to consist of different types of securities across different asset classes, industries, and regions that will have varying degrees of risk and correlation with each other’s returns.
Again, it’s important to note that any one investment strategy cannot guarantee against loss, including diversification, but spreading assets across investments that are not correlated to one another is a simple tool.
The risks of investing vary depending on the types of investments chosen. Each investor is going to have their own financial goals and their own period of time they would like to be investing.
There are various strategies for managing investment risk, but diversification is the easiest and one of the most effective tools. The stock market is prone to short-term fluctuations that often only impact certain industries, assets or regions.
Diversifying assets across those industries, assets or regions can help to mitigate any potential losses.
Choosing investments that have uncorrelated returns to the traditional stock market will further help to ease the risk of market volatility. Alternative assets such as Contemporary artwork have low correlation to stocks and bonds while also performing well in historical and recent periods of volatility.
You can start investing in blue-chip art with Masterworks today. Masterworks’ industry-leading research and acquisition teams use proprietary data and art market expertise to curate a collection of iconic works of contemporary art.
This material is provided for informational and educational purposes only. It is not intended to be investment advice and should not be relied on to form the basis of an investment decision