Understanding Investment Risk: What Investors Should Know

Investment risk is the chance that an investment's actual gains will differ from an expected outcome or return. All investments carry some degree of risk, and the main risk of investing is the possibility of losing money – you might not get back what you put in. The outcome of any investment is uncertain, largely due to the unpredictability of the market. The performance of a company's shares you own could take a turn for the worse, or economic issues could have a negative effect on the stock market more broadly. There are different measures of risk, including volatility, benchmarks, and goals. Volatility, or standard deviation, is a common metric associated with risk and provides a measure of the volatility of asset prices in comparison to their historical averages in a given time frame. The level of risk associated with a particular investment typically correlates with the level of return the investment might achieve. Risk and return go hand-in-hand – the greater the amount of risk an investor is willing to take, the greater the potential return.

Risk and return

Risk, in financial terms, is the chance that an investment's actual gains will differ from the expected outcome or return. It includes the possibility of losing some or all of the original investment. In the context of investing, the reward is the possibility of higher returns.

The relationship between risk and return is fundamental in finance. Investors need to be compensated for taking on additional risk. For instance, a US Treasury bond is considered one of the safest investments and thus provides a lower rate of return when compared to a corporate bond. Since the default risk of investing in a corporate bond is higher, investors are offered a higher rate of return.

The standard deviation is a common metric used to quantify risk. It measures the volatility of an asset's value in comparison to its historical average. A high standard deviation indicates high-value volatility and, consequently, a high degree of risk.

While it is impossible to eliminate investment risk, it can be managed through diversification. Diversification involves putting your money into a range of investments to reduce the impact of any single negative outcome. Mutual funds, for example, provide access to multiple assets at once and are a cost-effective way to diversify your investments.

The amount of risk in an investment depends on its composition. Lower-risk investments typically contain a mix of cash and fixed-income assets, while higher-risk investments may have more equities.

When deciding how much risk to take, it's important to consider your investment goals, risk tolerance, and time horizon. The longer your investment horizon, the more risk you can afford to take as you have more time to recover from market downturns.

Understanding the potential risks and rewards of investing is crucial for making informed decisions. By finding the right balance between risk and return, investors can achieve their financial goals while remaining comfortable with the level of risk they are taking.

Systematic and unsystematic risk

Investment risk is the chance that an investment's actual return will differ from what is expected—the possibility that an investment won't do as well as anticipated, or that you'll lose money. There are two types of investment risk: systematic risk and unsystematic risk.

Systematic Risk

Systematic risk, also known as market risk, is the risk inherent in the entire market and cannot be reduced by diversification within a portfolio. It is caused by factors that affect a large portion of the market or the market as a whole, such as macroeconomic changes, and is therefore often referred to as non-diversifiable risk. Examples of systematic risk include inflation, interest rate changes, recessions, currency changes, market crashes, and downturns. Systematic risk can be mitigated through asset allocation and hedging strategies.

Unsystematic Risk

Unsystematic risk, also known as specific risk, idiosyncratic risk, or company-specific risk, is the risk that is unique to a particular company, industry, or asset. It is caused by internal or external factors that affect only a specific organisation or industry, not the entire market. Examples of unsystematic risk include management issues, sales performance, market share loss, product recalls, labour disputes, and regulatory changes. Unsystematic risk can be mitigated through diversification, making it a diversifiable risk.

Liquidity risk

Market liquidity risk occurs when an enterprise cannot execute transactions at current market prices due to insufficient market depth or disruptions. Funding liquidity risk, on the other hand, 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 may deter lenders or investors from providing funding.

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. Banks and financial institutions are guided by regulatory frameworks, such as Basel III, which enforce stringent liquidity standards to ensure financial stability and protect depositors. Corporations, on the other hand, need to ensure they have sufficient cash or access to credit to meet their operational and financial obligations.

The repercussions of unmanaged or poorly managed liquidity risk can be severe. It can lead to financial losses, operational disruptions, and reputational damage. In extreme cases, liquidity risk can even drive an entity towards insolvency or bankruptcy. Therefore, it is crucial for both financial institutions and corporations to implement robust liquidity risk management practices.

For individuals, liquidity risk can pose a threat to their personal finances. Job loss or unexpected disruptions in income can lead to difficulties in meeting financial obligations. To manage this risk, individuals should maintain a reasonable budget, live within their means, and have an emergency fund to cover living expenses for several months. Additionally, diversifying investments and ensuring access to liquid assets or credit facilities can help mitigate liquidity risk.

Concentration risk

There are several ways in which concentration risk can occur:

• Intentional concentration: Investors may intentionally concentrate their investments in a particular sector or asset that they believe will outperform its peers or an index.
• Concentration due to asset performance: In a bull market, for example, stock holdings might come to represent a larger percentage of a portfolio than intended, due to their increased value relative to other holdings.
• Company stock concentration: Employees may be tempted to invest their retirement savings in the stock of their employer.
• Concentration due to correlated assets: Investments within the same industry, geographic region, or security type tend to be highly correlated. For instance, owning municipal bonds from the same state or region, or investing in technology companies and funds.
• Concentration in illiquid investments: Some investments, such as private placements, non-traded real estate investment trusts (REITs), and variable annuities, may be difficult to sell quickly and may impose surrender charges, limiting an investor's ability to access cash efficiently.

To manage concentration risk, investors can employ the following strategies:

• Diversification: Spread investments across and within major asset classes, such as stocks, bonds, and real estate. Ensure that stock holdings are diversified across different sectors and that bond portfolios are diversified by issuer and type, with varying maturity dates.
• Regular rebalancing: Periodically review and adjust holdings to ensure they align with investment objectives.
• Examine mutual funds and ETFs: Look "under the hood" of these funds to understand their positions and any overlap with individual stocks or bonds in your portfolio.
• Understand liquidity: Know how easily you can sell your investments, as some may be difficult to liquidate on short notice or without incurring significant costs.

Volatility

Volatile assets are often considered riskier than less volatile ones because the price is expected to be less predictable. The higher the volatility, the riskier the security. Volatile assets can carry greater risk and be detrimental to short-term goals. However, volatility is not always a good measure of risk, as it does not account for the probability of underperformance or actual loss.

There are several ways to measure volatility, including beta coefficients, option pricing models, and standard deviations of returns. Beta measures the volatility of an individual investment or specific market sector in relation to an underlying benchmark or overall market performance. A beta of 1.0 means an asset's volatility is equal to the market's. A beta below 1.0 means an asset is less volatile than the market, while a beta above 1.0 means it is more volatile.

Historical volatility is another measure of volatility, which looks at past market movements to gauge the degree of variability in an asset's price. It provides a retrospective view of volatility and helps investors understand how turbulent a market has been. In contrast, implied volatility reflects the market's forecast of future volatility and is derived from options prices.

While volatility and risk are related, they are not the same. Risk involves the chances of experiencing a loss, while volatility describes how much and how quickly prices move. If increased price movements increase the chance of losses, then risk is also increased. Volatility is often considered in the context of short-term investing, while risk can apply to both short and long-term investments.

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