Understanding Investment Risks
Investment risk can be defined as the chance of a loss occurring compared to the expected return of an investment.
Every single investment has some kind of risk associated with it. Even the money that you think is safe in a bank could be at risk. The bank, and also the Government could default. It’s not a high risk, but it’s a possibility.
There is also a risk of earning less interest through a bank account than the rate that inflation increases at. As an example, in Sweden, the inflation rate is sitting close to 2%, however money in the bank is receiving interest of 0,01% in a savings account, or 0,00% in a term deposit. Therefore, money is sitting stagnant in a bank account is actually loosing value.
Even burying money in your backyard or storing it in a house has associated risks. Someone could steal it, your house could burn down, or you make an impulsive buy for the newest car. Not Risk Free. Below I have identified 11 investments risks that you should be aware of. It’s about determining the:
- severity of the risk for an investment,
- how the risk can be minimised or mitigated,
- and then also determining your attitude towards risk.
Determining Severity of Investment Risks
When you invest in anything you must look at the risk vs the reward of a certain event happening. Once you have determined the chance of the event happening, you have to make sure that you are satisfied with the risk. Sometimes the chance of the event happening could be low, but the severity could be high.
Minimising Investment Risks
In order to minimise investment risks, there are a variety of methods that an investor can use. An investor can invest in multiple types of investments (Government bonds, Shares, Real Estate, P2P investments etc.), or invest in multiple versions of the same investment type (i.e. multiple shares, many houses in different countries etc.). These types of mitigation are referred to as diversification. A common way of doing this is to put just a bit of money into multiple investments in multiple countries.
Diversification is not for everyone though. One of the world’s greatest investors, Warren Buffet, only even purchased single companies. His reasoning behind this was that a person could invest a lot of time researching and understanding one business. Someone can know everything about the ins and outs of an industry and make a lot of profit. The average person cannot spend enough time watching and understanding many stocks spread out over many industries and asset classes.
Have a look here to see more about how Warren Buffett became the worlds 3rd richest man.
Gauging Risk Tolerance
Before you make any investments, it is important to understand all of the risks related to the investment, as well as the probability of that risk eventuating. It is important to understand all the risks related to each investment opportunity that you are presented with. The below list identifies some of the risks to be aware of:
Market risk is the risk that the value of your investment can change due to market events such as:
- Macroeconomic factors (i.e., interest rate, inflation, recessions)
- Social or political instability (i.e. war or presidential elections)
- Actions of other investors (i.e., mass sell-off of investments)
These events can lead to high rates of volatility and cause mass swings in the prices of assets.
An example of this is the stock market collapse in 2008. Massive economic failures of banks in the US caused chain reactions throughout world banks, in turn causing investors to sell-off of stocks and commodities worldwide. Ways to manage market risk include diversification in investment types and regions, and a long-term investment horizon.
Liquidity is the availability of liquid assets to a market or company. It’s the degree as to how quickly an asset can be bought or sold from another person (generally without affecting its price). The best example is to use shares. Over the space of 1 day, over 30 million shares of Apple Inc. are traded. If I wanted to buy some, there are a lot of people selling. However, in P2P platforms, liquidity swings can be more severe. An investor may invest substantial amounts of money into a platform that has many loans available today, only to find that there are no loans available. Suddenly, that money is sitting in an account not earning a return. Even worse, if the investor wants to sell the loans already bought, there may not be people interested in purchasing those. The risk here being that you are not able to sell, or you may need to sell at a lower price. In other asset classes (such as real estate), there could be a risk of additional expenses such as advertising and sales commissions.
Ways to manage liquidity include a proper understanding of what investment you are purchasing, having an up to date exit plan, and diversifying through other investment types.
Inflation Risk is the same risk level for every investment. A high level of inflation can decrease the expected return of your investments.
Ways to possibly manage inflation risk are to invest for shorter periods of time (i.e. 1 year)
Currency Risk (also Exchange Rate Risk)
Currency risk is the risk that an asset value will change based on the currency exchange at the time. The AUD to EUR value may be favourable today, but when you want to convert the value after you have sold your investment, the currency rate will most likely be different. As an example, the exchange rate between USD and EUR has fluctuated roughly 28% over the last 8 years. Currency risk can also be positive though, where you gain more value when converting back into your original currency.
Ways to manage currency risk can be to spend most of your investments in once currency (however this causes a market risk), invest through investments that are exposed to other currencies but remain in your currency (i.e. international managed funds), or to have a long investment horizon.
Political risk is the risk that an investment will change due to political decisions, events or conditions, or instability in the country. Examples of political risk include changes in government, civil unrest or military control. Political risks could be as simple as increased taxes on products (i.e. carbon tax, housing sale tax, etc.), currency valuation, spending, labour laws and trade tariffs.
Ways to manage political risk include long investment horizons, and diversification into other investment types or countries.
Regulatory Risk (also Legal Risk)
Regulatory Risk arises from Governments changing regulations and taxes around certain asset classes. The regulations could apply to either a business invested in, or an individual investor.
Ways to manage legal risk include diversification.
Interest Rate Risk
Interest Rate risks arise from changes in interest rate which can in turn affect the value of an asset. Generally, when the interest rate goes up, asset prices will fall.
Ways to manage interest rate risk are to have a long term horizon in your investments.
Specific risk relates to risks posed by certain types of assets. An example of this with Real Estate would include vacancy risks, tenant risks, location risks and oversupply risks.
Ways to manage specific risks include diversification.
Project risk arises from the investments themselves. Specifically in P2P and crowdfunding projects, marketplaces tend to specifically choose the investment opportunities that they make available to their investors. As an investor, there is a reliance on the marketplace conducting their due diligence when selecting loans.
Ways to manage project risks include investment in other asset classes, and understandings of how an investment type functions.
Operation risks apply directly to the medium used to purchase certain assets. Specifically, with P2P investing and crowdfunding, operational risks arise if the company that manages the investments goes into liquidation.
Ways to manage specific risks include diversification, and an understanding of each of the operations. Generally, an investor would want to look at whether the assets of a company are held separately from the assets that an investor would invest in. In such a case where the company would liquidate, the investor would still maintain their investments.
A concentration risk occurs when an investor has focused all of their investments in just one investment type (i.e. only P2P investments), investment region (i.e. investing everything into Australia), or investing everything into one specific investment opportunity (i.e. Apple shares, Bitcoin, etc.). As mentioned earlier, one way of managing concentration risk is to diversity between investment types, regions and specific investment opportunities.
Hopefully I have shown you that there are a magnitude of different risks associated with any type of investment. Knowing these risks can let you take a broader view of your overall investments, and can help you learn how different risks can affect your investment returns.
The above information is in no way financial advice and a proper analysis with a financial planner should be undertaken.