Risk refers to the degree of uncertainty regarding the outcome of an investment, and/or the potential for loss. The higher the risk, the higher the return needs to be in order for the investment to be attractive. Before investing, you need to consider your own risk tolerance and understand the risks related to your investment.
Risk can be either systematic (affecting an entire market) or unsystematic (affecting an individual asset).
Systematic risk (a.k.a. portfolio risk or market risk) is the possibility to experience losses due to events that impact the financial markets and affect all asset classes. For example, events like epidemics or weather catastrophes pose risks that can affect not only an individual stock, but potentially the whole stock market and also other markets. Diversifying your portfolio in one asset class does not mitigate market risk.
Unsystematic risk (also called specific risk) is a risk that relates to an individual asset. Unsystematic risk can be reduced with diversification across multiple assets and/or asset classes. For example, if the risks of two stocks are not directly related, a portfolio including these two stocks will be less risky than holding one of the stocks alone.
Broadly speaking, there are five general sources of risk described below, which lead to a loss in investment.
1. Equity Risk (Stocks)
When you buy shares of a company, the return of your investment is tied to the success of the company and how its stocks are valued. Equity risk is the risk that you experience a loss due to a drop in share prices. The stock market tends to be much more volatile than the bond market, and the value of your share can go through wild swings. If the company experiences a significant sales decline in one quarter, the price of it's stock may get affected significantly.
2. Interest Rate Risk (Bonds)
Bonds pay interest at regular intervals. If you invest in bonds and then later the interest rates increase, your bond holdings will be paying less interest than new bond issues. If you decide to sell your bonds before maturity, they will be worth less than your initial investment.
3. Credit Risk
If a company (or a government) that issued bonds runs into financial difficulties, if might not be able to pay interest or repay the loans at maturity. In case a company goes bankrupt, bondholders are first in line to get repaid and stock holders receive what is left.
The credit ratings of bonds indicate the creditworthiness of the issuer, and the likelihood that the debt will be repaid.
4. Inflation Risk
Over time, inflation erodes the value of money. There is a risk that your investment return is not sufficient to keep pace with inflation. This is especially relevant to bond and cash investments. Stocks and real estate typically offer high enough returns to offset inflation. If inflation hits, companies can charge more for their products and services, while landlords can increase the rent.
5. Liquidity Risk
It is possible that you may need to shorten you investment horizon due to an emergency. Liquidity risk refers to the risk of not being able to sell the investment, or to be forced to accept a lower price. This can be the case, for example, with investments that require a minimum holding period, or if you have to sell your stocks during a market dip.
How can you manage risk when investing?
Although risks can not be eliminated entirely when investing, you can take steps to prepare and plan your investments to keep risks at a level acceptable to you. Here are three simple ways that investors use to manage risks.
In simply terms, diversification is to not put all your eggs in one basket. The more assets you hold, the less you would be affected when one of the companies you invested in runs into financial difficulties. One easy way to obtain diversification is by investing in ETFs or mutual funds.
ETFs are investment vehicles that aim to track the the overall performance of a market or market segment, and hold a variety of a large number of assets. Mutual funds are similar to ETFs, with the main difference being that the aim is to not only track the performance of a market, but to perform slightly better than the market. ETFs and mutual funds exist for all the major asset classes, including stocks, bonds, cash, and real estate.
2. Asset Allocation
Asset allocation spreads your investments across multiple asset classes. Different asset classes have different characteristics and are prone to different risks. For example, the stock market tends to be more volatile than the bond market, i.e. there is a much greater equity risk. When stock prices dip, it can take months or years to recover. If you need to take out money from your investments before the end of your investment horizon, it is good to have less volatile assets that you can access instead of liquidating your stocks at low prices.
3. Dollar Cost Averaging
Dollar cost averaging (also called unit cost averaging), is when you invest equal amounts periodically over your investment horizon, regardless of market conditions. The goal is to avoid investing all your capital at a time when prices are high. With dollar cost averaging, there will be times where you will be buying cheaply close to a dip, and also times where you will by buying close to market high. The effects of price highs and lows average out over several years, amd you reduce the equity risk in your investment.
There is no attempt to gauge the price movements or time the market in dollar cost averaging. This also help address the emotional dangers of overconfidence when markets soar, and panic in the times when markets dip.
You can use dollar cost averaging, for example, by investing equal amounts each month at a specific date.
There are many ways investors can realize a loss in their capital. It is crucial to consider the risks and think about which risks are relevant for you which need addressed. Although not all risk can be eliminated, ensuring that your assets are diversified, utilizing a good asset allocation strategy, and dollar cost averaging can greatly bring down the risk and help you succeed in the long run.