Investment Risk: Is Your Money Ever Safe?

Investment risk is the degree of uncertainty inherent in an investment decision. All investments carry some degree of risk. The main risk of investing is the possibility of losing money – you might not get back what you put in. There are different types of investment risks, and each has its own impact on your investments. These include market risk, business risk, liquidity risk, concentration risk, and inflation risk. While it is impossible to eliminate investment risk, it can be managed through strategies such as asset allocation, diversification, and hedging. Understanding the potential risks and rewards of investing is vital to making informed decisions and ensuring your financial goals are met.

Liquidity risk

Market liquidity risk occurs when an enterprise cannot execute transactions at current market prices due to insufficient market depth or disruptions. Market liquidity is defined by the ease with which an asset can be exchanged for money. The risks are more pronounced in illiquid markets, where imbalances in demand and supply dynamics can make executing large transactions at a fair price challenging without affecting the market.

Funding liquidity risk is the inability to obtain sufficient funding to meet financial obligations. This is often a reflection of the entity's mismanagement of cash, its creditworthiness, or prevailing market conditions, which could deter lenders or investors from stepping in to help. For example, even creditworthy entities might find it challenging to secure short-term funding at favourable terms during periods of financial turbulence.

Effective liquidity risk management involves ensuring the availability of sufficient cash, liquid assets, and accessible borrowing lines to meet both expected and unexpected liquidity needs. Common ways to manage liquidity risk include maintaining a portfolio of high-quality liquid assets, employing rigorous cash flow forecasting, and diversifying funding sources.

The repercussions of unmanaged or poorly managed liquidity risk can be severe and far-reaching. It can lead to financial losses, operational disruptions, and reputational damage. In extreme cases, liquidity risk can drive an entity towards insolvency or bankruptcy.

Market risk

The most common types of market risk include interest rate risk, equity risk, currency risk, and commodity risk. Interest rate risk refers to the volatility that may accompany interest rate fluctuations, which is most relevant to fixed-income investments such as bonds. Equity risk pertains to the changing prices of stock investments. Currency risk, or exchange-rate risk, arises from changes in the price of one currency relative to another, impacting investors or firms holding assets in another country. Commodity risk covers the changing prices of commodities such as crude oil and corn, which can affect investors who invest directly in commodities or companies heavily reliant on these materials.

While it is not possible to completely eliminate market risk, investors can employ hedging strategies to protect against volatility and minimise its impact on their investments. For instance, purchasing put options can safeguard against downside moves when targeting specific securities. Additionally, diversifying investments across different asset classes, industry sectors, and geographic regions can help weather significant market shifts.

Operational risk

There are seven primary categories of operational risk:

• Internal fraud
• External fraud
• Technology failures
• Execution, delivery, and process management
• Employee practices and workplace safety
• Natural disasters and damage to physical assets
• Clients, products, and business practices

Credit risk

While credit risk is a concern, it is worth noting that the risk is generally lower than it is for stocks. This is because, in the event of bankruptcy, a company must first pay back the bondholders before shareholders can receive anything.

Political risk

• War, terrorism, and civil unrest
• Unilateral decisions made by state-owned entities
• Geopolitical decisions by governments, including foreign trade policies, tariffs, legal and regulatory constraints, tax regulations, and currency controls
• Sanctions
• Jurisdictional risk, especially when contracting with partners in other countries
• Import and export issues, where sanctions or restrictive measures can disrupt supply chains and devalue goods
• Restriction on currency exchange or transfer, which can impede cash flow and threaten profitability
• Political unrest and forced exit, where businesses may need to abandon assets in dangerous situations
• Expropriation and discrimination, where foreign governments may seize assets or deprive businesses of their revenues

Frequently asked questions