Investment Risk, Explained
Benjamin Franklin once said, "In this world nothing can be said to be certain, except death and taxes." We at FINRA would like to propose adding a third certainty: investment risk.
There is no such thing as a
risk-free investment. Stocks,
bonds, mutual funds and
exchange-traded funds can
lose value if market conditions
sour—and even cash can fail
to keep up with inflation.
There is no such thing as a risk-free investment. Stocks, bonds, mutual funds and exchange-traded funds can lose value, even their entire value, if market conditions sour. And even conservative, insured investments, such as certificates of deposit (CDs) carry their own kind of risk: inflation risk (more on that later).
Because investment risk is a given, it is up to you to understand those risks so that you can confidently decide what to do with your financial assets.
There are two broad categories of risk to consider. First, there is business risk. Business risks, or "non-systemic" risks, are any risks associated with investing in a particular product, company or industry.
The second broad category to consider is market risk. Market risk affects the overall economy or securities markets. It is the risk that an overall market decline will knock down the value of all investments, regardless of their individual strengths or weaknesses.
Here's a look at nine common types of investment risk.
- Management Risk – This is inherent to a company's day-to-day operations. For example, the risk that a company's key product line is discontinued, that production costs soar or that a key executive leaves, potentially impacting the value of the company or its ability to repay its debts. These risks vary by company and sector.
- Credit Risk (or default risk) – The risk that a bond issuer will fail to make interest payments or to pay back your principal when your bond matures.
Bonds face a variety of other unique risks, including duration and call risk. For more on the risks unique to bonds, check out Understanding Bond Risk.
- Sociopolitical Risk — This involves risk related to political and social events such as a terrorist attack, war, pandemic or elections that could impact financial markets. Such events, whether actual or anticipated, can affect investor attitudes and outlooks, resulting in system-wide fluctuations in stock prices.
- Country Risk — The risk that events in the country in which an investment is made could impact general market sentiment. This can occur when a country overhauls its government, changes its policies, or experiences social unrest or war.
- Currency Risk — Any change in the exchange rate between two relevant currencies can increase or reduce your investment return. You probably have exposure to currency risk if you own stock in a foreign firm or in a large U.S. company with significant foreign sales.
- Interest Rate Risk — This is the risk that the value of a security can fluctuate due to changes in interest rates. Interest rate changes directly affect bonds — as interest rates rise, the price of a previously issued bond falls; conversely, when interest rates fall, bond prices increase. The rationale is that a bond is a promise of a future stream of payments; an investor will offer less for a bond that pays-out at a rate lower than the rates offered in the current market. The opposite also is true.
- Inflation Risk (or Purchasing Power Risk) — The risk that general increases in the prices of goods and services will reduce the purchasing power of money, and likely negatively impact the value of investments. Inflation and interest rate risks are closely related as interest rates generally go up with inflation. But inflation can also be cyclical. During periods of low inflation, new bonds will likely offer lower interest rates, which may lead investors to higher-risk bonds offering higher rates.
- Liquidity Risk — The risk that you won't be able to buy or sell investments quickly for a price that tracks the true underlying value of the asset, or that you won't be able to sell the investment at all because of a lack of buyers in the market.
- Legal Remedies Risk — The risk that if you have a problem with your investment, you may not have adequate legal means to resolve it. When investing in an international market, you often have to rely on the legal measures available in that country to resolve problems. These measures may be different from the ones you may be used to in the US.
Managing Your Investment Risk
While you cannot avoid investment risk, you can manage and take steps to minimize your exposure. But to do that, you need to first understand the types of risk you face, because different investment products are susceptible to different types or risk.
One of the best ways to manage your risk is to diversify your investments. Both business and market risks can be mitigated to a certain extent by diversification — not just at the product or sector level, but also in terms of region (domestic and foreign) and length of holding periods (short- and long-term). You can spread your international risk by diversifying your investments over several different countries or regions.
On top of that, you can manage your risk by doing your homework. Learn about the forces that can impact your investment. Stay abreast of global economic trends and developments. If you are considering investing in a particular sector, read about the future of that industry. If you are considering investing in a particular country, be sure you understand the local market and political situation.
Finally, consider your options and your own risk tolerance. Learn more about the various types of investments options available to you and their risk levels. Some investment products are more volatile and vulnerable to market risks than others. And some sectors and businesses face more business risks that others.
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