There is not a week that goes by without discuss worries and concerns about the stock market and investing. Of course, there are tons of things in this lifetime to be worried about. You name a situation, and there's going to be something you can find to worry about, that's for sure. However, what I find tends to seriously worry the people I work with is where their money is going and how it's performing.
When working with a financial planner , coach or financial advisor representative, what you'll find is that your money should experience incremental and steady growth over a long period. However, some situations are out of anyone's control that have the potential to make an impact on this growth. Some of these situations could be natural disasters, others could be broad economic conditions or industry-specific catastrophes.
Events and situations like these come in many forms, but what we're really talking about boils down to one thing… risk. Risk is something that different people have different tolerances for. It can also be challenging to measure and account for at times, especially when something totally unforeseen happens… like a worldwide pandemic that shuts down multiple first-world economies for an unspecified amount of time (ahem, 2020, we're talking about you).
Today we're going to be talking about various risks involved with investing. Of course, it's no secret that investing comes with a certain amount of risk, which varies between types of investments, industries, businesses, and timelines. However, you probably don't know just how many types of risks that there are! Don't worry; we're going to cover as many as possible, describe what they are, and discuss different ways to avoid, mitigate, and preemptively plan for these risks. We're also going to discuss how individuals respond to risk, tradeoffs that come with taking risks, and answer the question, "are there any totally risk-free investment options?".
Let's start with the basics! You probably already have a pretty good idea of what risk is in relation to investing, but let's outline it regardless! Risk, in essence, is the possibility that a predicted outcome will be different than anticipated outcome. In other posts, we've discussed the idea that there's an inextricable tie between investing and uncertainty. In other words, it's basically impossible to know beforehand how an investment will perform because the actions are taken that will create or destroy value haven't yet happened. Sure, we have predictions and estimations that can be very accurate, but it all boils down to the fact that no one can predict the future.
Without getting too into the weeds with mathematics and specifics of how these things work, you should know that while risks do exist, so do measurements of risk. Those in the financial field use these measurements to discuss, plan, and create strategies to help overcome and manage possible adverse outcomes of investments. Specifically, regarding investing - risk means that there is a possibility (varying in likelihood) that an investment may perform differently than expected.
Broad Categories of Risk: Systematic and Unsystematic
There are essentially two overarching and broad categories of risk that every investor takes on. These are known as Systematic and Non-systematic risk.
Systematic risk, also referred to as market risk, is built into all investments. It is the risk that you take on simply by investing because there is always a possibility that a business, sector, or the economy as a whole could fail. Unfortunately, this type of risk is large-scale and can't be diversified out. With systematic risk, there's a possibility that a business entity, a sector, or the economy could crash in a way that creates a domino effect that causes volatility across markets and economies.
Non-systematic risks, or idiosyncratic risks, can be thought of on a smaller scale. They're risks that affect individual or smaller groups of investments. In other words, perhaps a business or a market underperforms - this doesn't affect the market as a whole, thus won't harm the performance of all items in your portfolio. Another notable difference between systematic and non-systematic risks is how they can(or can't) managed through diversification. However, if you're already reading this, you likely already know that diversification mitigates risk in investing by spreading investments across different businesses and industries. So while systematic risk can't be diversified out of a portfolio, non-systematic risk generally can be significantly mitigated by spreading your money among multiple investment prospects.
I know that's a lot to take in and quite possibly difficult to wrap your head around. So, if you're looking for a TL:DR (or too long; didn't read) summarization - systematic risk is broad, wide-reaching, affects a large portion of the economy, and can't be diversified out of a portfolio. In contrast, non-systematic risk is smaller-scale, affects a smaller number of businesses or markets and can be, at least, moderated in a portfolio through proper diversification strategies.
Specific Types of Risk
Each specific type of risk will fall into either the systematic or non-systematic categories. I'll attempt to summarize as many particular types of risk as possible in much fewer words than I have above.
Equity risk is relatively easy to understand. Essentially, equity risk is the risk you take that the equity you purchase in a company will drop between the buying and selling process. This means that you're risking the share price of your investment could lower after you purchase it, meaning you will not be able to sell it for the same or more than you bought It for.
Interest Rate Risk
Interest rate risk is very similar to equity risk. However, the main difference is that equity risk applies to shares/equity in a company while interest rate risk applies to debt investments or bonds. When you purchase a bond, you risk that the interest rate may increase, which would devalue the bond.
Liquidity Risk/Marketability Risk
Liquidity in finance refers to the ability for an investment to be sold promptly. The more liquid an investment is, the faster it may be sold. Liquidity usually is due to supply and demand; however, supply and demand can be altered based on external factors like government involvement, policy changes, geopolitical occurrences, and natural disaster. Liquidity risk is the chance you take that an investment may be less liquid after purchase. This makes it more challenging to sell and could cause you to take a loss by forcing you to sell at a discounted rate. Liquidity risk can, in extreme circumstances, make it nearly impossible to sell an asset.
Currency Risk/Exchange Rate Risk
When purchasing foreign investments, you must be aware of currency risk. You take on currency risk when buying a foreign investment because there's a chance that the foreign country's currency may depreciate in value. Therefore, when purchasing foreign assets, you must be on the lookout for the exchange rate between your home country (the United States) and the country where your investment originates. A change in the exchange rate may make your investments worth more or less in either currency.
By now, we've talked a bit about portfolio diversity or the practice of keeping multiple types of investments across various industries as a way to not put all of your eggs in one basket. Concentration risk is the opposite of diversity. Concentration risk is the risk of your assets/investments failing due to too little variety. This means that your investments could all be stocks, bonds, all be in the metal industry or all be in the United States. The risk you take through over-concentration could prove very harmful to the overall health of a portfolio, especially in times of stark financial instability or decline.
Inflation Risk (Purchasing Power Risk)
Assets that are cash or debt investments, like fixed-income, are susceptible to inflation risk. This is the chance that over time inflation will overtake and outpace your investment. This means that your money's purchasing power has declined while it has been invested. Assets that aren't affected typically have ways that their investment moves with inflation.
Credit Risk/Default Risk
With debt investments, like bonds, you also take on credit or default risk. This is the risk that your investment will not be honored through interest and principal payments because a business has had financial difficulties. While bonds are typically seen as safe investments, they're also rated based on their credit risk. These ratings give you an idea of how viable a business or entity is to default on your bond because of financial issues. Bonds with higher credit/default risk tend to have higher interest rates (high risk/high reward).
An easy way to think of credit risk is by thinking of your own credit card. The bank you use takes credit or default risk by issuing you a credit card and allowing you to use it. There's a chance you'll default because of financial difficulties, but the bank sees that risk and assigns you an interest rate and credit limit based on how likely you are to pay back the money you borrow.
Reinvestment/Reinvestment Rate Risk
With bonds, the higher the interest rate, the more money you will receive periodically until the bond reaches maturity. Reinvestment or reinvestment rate risk is the chance that the interest rate will change as you reinvest in a bond. Generally speaking, the longer the bond term, the higher the chance of reinvestment rate changing. As the name suggests, this type of risk applies to bonds that are being reinvested, but it is also applicable to stocks that pay dividends.
The older one gets, the more likely they are to run into longevity risk. This is the risk that your will outlive your assets. Or, to put it more bluntly, this is the risk that you will run out of money before you die. This risk is obviously less the younger we are and dramatically increases as we age.
When one purchases an asset or investment, they often (and should) do so with an overarching plan in mind. Part of this masterful plan is about how long one will hold an investment before selling it, or it reaches maturity. Horizon risk is the risk that your investment won't be allowed the necessary time to reach its potential because you'll be forced to sell, or it will be prematurely repurchased from you. Horizon risk increases as either the investor's or investee's cash flow changes. For example, a business may prematurely buy back their bonds, which means they didn't get the chance to reach full maturity. Alternatively, you may need to sell an investment because you're in urgent need of liquid cash.
Foreign Investment Risk
Foreign investment risk is similar but different from currency risk. When investing in foreign entities, whether it be a business or government, you're taking on many unknowns. Mainly, you're putting a lot of faith into a business or government that nothing completely unexpected or wild will happen in their regulations or politics. Foreign investment risk is just that, the risk that something unknown and unexpected will occur, like a regime change, invasion, or harsh policy declaration.
Risks are honestly a subject that goes on and on and on. I've outlined some major ones here, but there are numerous (and I mean numerous) others that are both broad and specific. While it would be nearly impossible to outline all types of risk, the ones outlined here should give you a general idea of the scope of thought required to take on investing. This is one (of many) reasons that investing with a great financial planner is a great idea. It's obviously complicated for anyone to keep track of all risks and take them into careful consideration when investing. Still, it helps if your career is built on identifying and mitigating risk.
Are There Investments Without Risk?
I've teased the answer to this question a few times throughout this post. There are no investments that are entirely free of risks. Of course, some assets are much less risky, and some are much more risky, but all investments have a risk baseline. This is inherent because of the nature of investing. Because no one can perfectly predict the future, each investment comes with a specific set of risks. The key, of course, is knowledge of risk and different risk factors that allow you to create a plan, strategize, and evaluate opposing outcomes that will ultimately help you make sound judgments and decisions.
The best way to mitigate risk while investing is by creating a relationship with a great financial planner. We're people who help our clients develop plans and evaluate risk each and every day. So whether you'd like to begin talking about investing or just learn more about investment risks and how they could affect your overall financial plan, please, feel free to call or email to schedule an appointment with me. Together, we can create a financial plan that keeps your risk profile in mind and align your investments with your financial needs and goals.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is also a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.