We all take risks in the hope of gaining something—buying a home, changing careers or marrying. Investing, like many other things in life, involves risk in order to achieve return.
While it is normal to be concerned about the security of your money, a narrow perception of risk can be limiting. In fact, by understanding investment risk and how it relates to potential returns, investors can help strengthen their portfolios and improve their chances for greater wealth.
Investing for your long-term financial security can be daunting.
There are many decisions to be made and one of these is how much risk you are prepared to take. This will be determined by a number of factors. Many investors view risk as the possibility of losing money, but it is really much more complex.
Because of its multifaceted nature, risk can affect your investment in a number of ways. To assist you decide on the types of investments that can help meet your financial goals, this article takes a look at the different types of investment risk.
FOREIGN INVESTMENT RISK
There are a variety of risks involved with international investing. Foreign markets may be less mature and less regulated than local financial markets; the issuer of an international security may be subject to greater political or economic uncertainty, and foreign securities can gain or lose value when converted from one currency to another. However, international investing gives investors the opportunity to participate in a broader range of companies and economies.
Market or downside risk economic factors, such as recession, inflation or changing interest rates, can all influence the overall movement of the markets, thus affecting the value of your investment.
The risk of investments declining in value because of economic developments or other events affects the entire market
The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. This may force you to sell investments that you were expecting to hold for the long term. If you must sell at a time when the markets are down, you may lose money.
The risk of being unable to sell your investment at a fair price and get your money out when you want to. To sell the investment, you may need to accept a lower price. In some cases, such as exempt market investments, it may not be possible to sell the investment at all.
As shown in the following chart, fixed income and cash investments will generally be lower risk (defensive assets), and assets such as real estate investment trusts and shares are generally considered to be higher risk (growth assets).
The risk that the government entity or company that issued the bond will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity. Credit risk applies to debt investments such as bonds. You can evaluate credit risk by looking at the credit rating of the bond.
The risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a bond paying five per cent. Reinvestment risk will affect you if interest rates drop and you have to reinvest the regular interest payments at four percent. Reinvestment risk will also apply if the bond matures and you have to reinvest the principal at less than five percent. Reinvestment risk will not apply if you intend to spend the regular interest payments or the principal at maturity.
The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. Inflation erodes the purchasing power of money over time – the same amount of money will buy fewer goods and services. Inflation risk is particularly relevant if you own cash or debt investments. Shares offer some protection against inflation because most companies can increase the prices they charge to their customers. Share prices should therefore rise in line with inflation. Real estate also offers some protection because landlords can increase rents over time.
The risk of loss because your money is concentrated in one investment or type of investment. When you diversify your investments, you spread the risk over different types of investments, industries and geographic locations.
Your appetite for risk will depend on your life stage and whether you want to grow your savings over the long term or need to draw a regular income. Usually, your age and relative proximity to retirement will determine whether you’re investing for the short term, medium term or long term. While awareness of risk can lead an investor to make prudent decisions, it is possible to be overly cautious. "Safe," low-interest cash investments, like money market funds, for example, is excellent choices for preserving assets once you approach or achieve your goal. But over the long-term, they generally cannot provide the capital appreciation needed to meet a significant investment goal.
All investments involve risk. In my next article, I shall write on strategies to manage them and pursue your financial goals with more confidence.