7 Types of Investment Risks You Need to Know And Watch
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Risk is a fact of life. It’s the possibility of something bad, something unexpected happening. Everything we do bears some level of risk. There is life risks, business risks, relationship risks and yes, investment risks.
However, all around us we see offers that promise to give us so much in return for little effort and without any form of risk. As a matter of fact many people now look out for such offers.
There’s a craze for no risk, high return investment.
I receive a lot of mail asking me for recommendations of investment schemes that offer very high return but without risk at all.
This tells the mindset of the average individual about investment. They want to double their money in a very short period of time, some as short as 14 days. Without any form of risk!!!
And needless to say that it is mindsets like these that make fraudulent investment schemes to thrive. Fraudsters feed on the greed and ignorance of their victims.
The truth is that there’s hardly any type of investment that does not bear some risks.
There are quite a number of factors that can alter expected outcomes. Market fluctuates, economic conditions do change and even an unexpected change in government policy can mess up a priori expectations.
Understanding the risks that is associated with a proposed investment and knowing how to mitigate them is the key to successful investing.
Here’re are some of the investment risks you should know about.
What Are Investment Risks?
Simple. It’s the probability that you will lose all or part of your money in an investment. Or at best fail to get the amount of return you expected.
There’s a risk-return-trade off. That means that the higher the probability that a loss will occur, the higher the return expectations. This is a common investing rule but one which many people either don’t understand or simply undermine when taking an investment decision.
The higher the risk, the higher the return and the lower the risk, the lower the return.
So when next they make you an offer promising to give you back threefold of what you invested in a week’s time, guaranteed without any risks; query it. It is probably a bait on your greed and ignorance.
Every investment has a risk. There could be a low risk, high return investment but certainly not No Risk, High Return Investment.
Some risks are systemic, embedded in the market. Some are specific to asset classes. Here are some of the common investment risks you should know.
Types of Investment Risks
#1. Market Risks
These are events that affect the performance of the financial market generally. The investor does not have control over these events. It is systemic and thus, impact negatively on the entire market.
For example, economic recession may cause depression in stock prices. Market risk is one of the major investment risks. It is non-diversified and cannot be mitigated by a portfolio diversification strategy.
#2. Interest Rate Risk
Interest rate is the cost of money (or professionally put, cost of fund).
Changes in interest rate will affect prices of securities. For example, an increase in interest rate will lead to a fall in the value of bonds. It also affect corporate earnings and stock prices negatively.
Usually the central monetary authority of a country, such as the Monetary Policy Committee of Central Bank of Nigeria or the Federal Open Market Committee of the Federal Reserve Bank in United States, set the benchmark for interest rates.
There’s certainly nothing anyone can do about interest rate fluctuations and how they affect the return on your investment. However, having the capacity to analyze the economy and being able to predict the direction of interest rate is necessary for successful investing.
#3. Inflation Risk
Inflation is a condition of persistent rise in price levels. And it is a risk when it comes to investment because it has the capacity to decrease the value of an investor’s asset.
It’s also called purchasing power risk because, rising price levels negatively impacts the future cashflow from an investment. For instance, if 100 USD can afford you a piece of shoe today, and you put that amount in an investment that earns you 10% annually. In the next one year that 100 USD will be worth 110USD.
But can you still afford that pair of shoe with your now 110 USD if inflation is say, at 16%. Let’s see.
At 16% the shoe will now cost 116USD. So, even with the return on your investment, your 110USD can no longer afford you the pair of shoe you could have bought with ease last year.
That’s the impact of inflation on investment. Particularly fixed income investments.
#4. Currency Risk
This risk occurs when you invest in another country or in foreign currency. It’s the risk that comes with fluctuations in exchange rate.
Watch out for for this risk when you are buying foreign stocks, investing in a foreign business or even trading with another country. Your money may worth nothing if you are trading with or investing in a country with volatile foreign exchange regime.
For instance, Nigerian retail investors are rushing to take advantage of the many investing app available to invest in U.S stocks. This is because the U.S dollar is obviously valuable relative to the Nigerian Naira. If the situation suddenly reverses and the Naira becomes more valuable, the value of those investment in U.S stocks will fall like a pack of cards in Nigeria Naira terms.
#4. Liquidity Risk
Liquidity has to do with the level of ease with which an investment can be sold at any time. That’s the ability of the investor to get buyer easily whenever he wants to exit an investment.
Liquidity is one of the most common investment risks. It is a non-market risk and this means that it may be specific to an asset class. Of of what use is it that one has an investment that is worth so much, but one which he cannot sell whenever he wants to.
So whenever you are considering to make an investment, ensure to confirm that there will always be people willing to buy from you when you desire to sell and claim your profit.
Liquidity risks are usually associated with variable asset classes whose potential return is not known in advance and cannot be guaranteed. Stocks, cryptocurrencies, etc are such asset classes.
#5. Concentration Risk
This risk comes from investing all your money in one asset class. When something untoward happens to the that market, your investment is at risk. For instance, you have 100,000 to invest and you put all in equities; if the equity market melts down, you are stand the risk of losing all your money.
That’s one of the reasons financial advisors advise you to diversify your investment by spreading your risk over different asset classes or across industries.
#6. Industry Risk
Also known as Business Risk. Business Risks are those challenges that a peculiar to an industry and that are likely to affect businesses operating in that industry. They are uncertainties that face an industry which if not properly taken care of by the operator will affect expectations.
It is important that when you want to invest, consider the peculiar industry challenges that may likely affect business expectations, hence profitability and returns.
An example is the oil and gas industry. This industry is subject to price volatility. In addition, it is continuously threatened by the discovery of alternative energy. All these affect the stock prices of oil exploration companies.
If you are investing in the stocks of oil exploration companies, you have to pay attention to these factors if you desire to make any success out of it.
#7. Company Risk
This is the danger that you may lose money due to factors that are specific to the company you are investing in. It’s important that when you are buying shares of a company for example that you conduct due diligence on that company.
This due diligence forms part of your fundamental analysis. It helps you dissect issues which are internal to the company that are capable of affecting their going concern, ability to pay debt or even make profit.
Is the management of the company qualified and reliable? Is there business model well thought out? How do the create value, etc?
How to Manage Investment Risks
Now you know what investment risks are! How can you mitigate them or manage them to achieve success in your investing journey?
All the actions an investor takes to mitigate or limit the impact of investment risks on his portfolio is known as risk management strategy.
Here’s some guide
#1. Know Your Risk Appetite
The first step to managing risks is to know your risk appetite.
Be honest with yourself when making investment decisions. How much risk can you take? In most cases, your risk appetite is a function of the following:
How much money you have to invest? The more money you have, the more risk you may afford to take
Your investment time horizon: how long are you willing to stay on the investment. Usually, the longer, the better. Staying longer in an investment help even out the risk
Current commitment, and sometime future commitment also play a role in the amount of risk one is willing to take. If you have immediate needs to meet, it’s unlikely that you will be willing to take much risk or invest for a longer term.
#2. Diversify Your Portfolio
One of the only best ways to invest successfully is to diversify. Diversification involves splitting your money in different asset classes rather than putting all your eggs in one basket.
This will drastically reduce the risk of losing all your funds. The rationale behind diversification simply involves spreading your funds to different investment opportunities. This way, in the event of a loss occurring, it will not affect all your different assets and securities.
As a matter of fact, diversification helps you to finish with a net gain. That is, while some investments might falter, others will grow and that way you have a positive net position.
However, the challenge here is that most people don’t know how to diversify effectively. The effective way is to invest in a mix of assets that are negatively correlated.
Negatively correlated assets are not affected by the same market trend. While assets that are correlated move in the same direction, hence can be affected by the same market trend.
#2. Invest Consistently
Another great way to manage or control your investment is by consistently investing a fixed amount, regularly. Overtime, you would have invested a large amount. Investing small amount consistently, helps minimize sudden losses.
When someone advised that you should invest only amount you can afford to lose; this is what he probably mean.
Investing fixed amount at intervals whether the market is up or down over a long time will result to a lower average cost per share.
#3. Invest Long Term
The third investment risk management strategy on this list is for you to invest over a long period of time. It has been proven that investing over a long period of time will drastically reduce risk.
Within a long holding period, the price of an investment may of course rise and fall, the losses incurred during the low periods will surely be regained back over a long period of time.
Stock is known to be one of the riskiest asset classes. However, the tendency to lose big is higher when you invest for a short time.
But when you invest for a long term, the return on stocks usually outpaces other asset classes. By the way long term investment is one that you hold for period of say 10, 15, and 20 years.
This way, losses can be recovered and risk is effectively and efficiently managed for better returns.
#4. Asset Allocation
Asset allocation is the distribution of your investment capital amongst various asset classes. It’s a risk management strategy.
How you distribute investment is a function the following:
What your investment goals are?
How long you want to stay in the investment?
How much risk can you take?
There’s a risk element in every investment. As a matter of fact, the higher the risk, the higher the expected return. The reverse is also true.
Without proper risk management strategy, you could lose all your money. That’s why it is important to understand risks and take steps to manage them.
Buchi provides small business owners with strategic, financial, and digital support to help them build strong, successful and profitable enterprises. He is a Blogger at night and by day, Team Lead at Stalwart Investment Partners Ltd, a research, business and investment advisory firm.