Understanding investment risks
- Financial Planning
We all know that risk level is a factor in any investment. It is often talked about in relation to share and property investments where values can fluctuate rapidly, but even more conservative investments carry some form or risk with them.
So what drives the risk level of an investment? Some influences are fairly obvious, but some are perhaps a little more obscure. To help you get a better understanding, here is a quick guide to the major types of risks and how they can affect an investment.
This is perhaps the most familiar type of risk for personal investors. Market risk refers to the possibility of the value of an investment dropping, due to the forces acting on a particular market, such as economic conditions, supply and demand dynamics, market sentiment and business performance results. This is most obvious in the share market, where values fluctuate up and down on a daily basis. The value of an investor’s stake in that market is directly affected by those movements.
An additional layer of market risk comes into play when investing in overseas markets. A change in currency exchange rates can have an effect on the ultimate value of an investment on top of any change in value on the market itself.
Market risks also apply to fixed interest type investments. For example, a shift in interest rates can affect the market value of the bond.
This one is often overlooked by personal investors, but can be one that has big impacts. Liquidity risk relates to a situation where you have to sell your investment at a discount if you need to ‘cash out’ suddenly. This can happen if you do not have sufficient liquid funds on hand and are caught in an emergency situation where you need ready cash.
Having to sell a share or property investment in such a situation may mean you have to accept whatever the market price is at the time, which may be lower than it would be if the investment was allowed to run its full term.
Evaluate the risks and challenges before jumping into a major investement decision
This type of risk is a little less easy to quantify or identify, but is a significant factor all the same. It relates to the risk you take when you concentrate your investment all in the one market or asset type, thereby leaving yourself exposed to the performance of that one market or asset.
Concentration risk is alleviated by diversifying investments across various markets and assets, because different markets may perform well at different times and having a spread of investments will help to take advantage of this dynamic and allow you to balance or ‘average out’ your investment returns over time.
This type of risk refers to bond investments issues by governments or companies. If the issuing entity experiences serious adversities they may reach a situation where they cannot honour their commitment to pay the interest or repay the original investment amount at maturity.
While the chance of this occurring is low, it is still a possibility – especially in times of global economic crisis or political instability. The level of credit risk on such investments can be gauged by the credit rating that is attributed by ratings agencies on the entity that is issuing the investment.
This is one risk that can affect those investors who are trying to avoid other types of risk, such as market risk. If you place all your investments in cash or fixed interest type investments so as to avoid market risk, then inflation may outperform the return you are earning on your investments and you are therefore suffering a net loss in your overall position.
Inflation risk is another reason why holding a diverse portfolio can be a wise decision (depending on your personal situation, the amount you have to invest and the timeframe you are investing for). Holding a proportion of your investment in market linked investments, such as shares, gives the potential to gain higher capital and income returns that can offset the impact of inflation. Share investments can also sometimes benefit from periods of inflation because the ability of businesses to charge higher prices for their goods and services can assist in their share price growth.
Your investment time horizon, (the amount of time you expect to be able to hold an investment for), is an essential factor in choosing the right investment type or mix of types. You may have the best of intentions when planning a portfolio that your horizon is several years, but unexpected events such as loss of employment or additional living expenses may cut that horizon short and force you to sell some of your investments at an unfavourable time. This underlines the need to be careful when planning your time horizons and having contingency plans that will not leave you overly exposed if circumstances change.
This is a risk that is particularly relevant to retirees who depend on their investments as a main source of income. Longevity risk occurs when you end up living longer than you may have expected and you are unable to maintain the same level of income in later years. This is one risk that needs to be carefully assessed at the time of setting out your retirement income strategy.
Foreign investment risk
Apart from the exchange rate risk mentioned earlier, investing in a foreign country’s market may also carry inherent risks such as political instability, natural disasters, conflicts and financial crises in that country.
How to manage these risks
The diverse range of risks faced by personal investors makes it essential to plan strategically and review regularly to keep risks in check and to make adjustments where appropriate. This is where a financial adviser can be of benefit in helping you make a thorough and objective analysis of the risks that affect your situation.
What do you feel are the major risk factors facing personal investors today? Share your thoughts below.