When it comes to building wealth, some investors focus on growing their money as fast as possible. Meanwhile, others focus on protecting themselves against market corrections or preserving their wealth. However, any financial investment you make will inherently carry risks, including bonds, stocks, real estate, cryptocurrencies, etc. The key is to manage investment risk carefully to ensure that you do not take on more than you can handle.
- You can make informed and levelheaded decisions by understanding the costs, trade-offs, and potential returns of different types of investments.
- There are many types of investment risks to consider, such as business risk, inflation risk, and more.
- Three factors that affect risk tolerance include emotions, needs, and risk capacity.
- There are several investment risk management strategies you can leverage to manage risk successfully.
What is Risk?
Whenever we invest, we naturally want to be optimistic about our assets’ growth potential. But, we should never completely rule out the potential downsides. That is where risk comes into play. In the financial context, risk is the possibility of things going wrong. For example, when you purchase a home, there is no guarantee that its value will rise over time. If you decide to rent it out, there is no guarantee that you will have a perfect tenant.
Though you cannot guarantee a return on your investments, there are a few factors you can control. For example, before buying a property, you can hire a home inspector to look for potential red flags, such as a crack in the foundation or lead exposure. Before investing in a specific stock, you can research the company to ensure they provide a solid product or service, have experienced leadership, and are financially healthy.
8 Types of Risk to Beware Of
Common types of investment risks include:
1. Business Risk
Companies or organizations have to factor in the possibility of not meeting profit targets or failing. Anything that hinders a company’s ability to deliver on its profit goals is a business risk. Factors that can create business risk can be internal, such as poor management or inability to adapt to the times, or external, such as lawsuits or scandals.
2. Currency Risk
If you invest in foreign currencies, you risk losing money due to fluctuations in the exchange rate. Most of us have probably heard of the horror stories of hyperinflation in Venezuela, whose central government started printing 200,000, 500,000, and 1,000,000 bills in March 2021. No matter what currency you invest in, including the US dollar, they can run the risk of losing value over time or becoming outdated.
3. Credit Risk
Credit risk refers to the risk of loss due to a borrower failing to pay back a loan or meet contractual obligations. For a lender, credit risk is the possibility of not receiving the principal and interest owed. However, credit risk can also apply to debt investments, such as government or corporate bonds. In return for assuming credit risk, a lender or investor will often receive interest payments.
4. Equity Risk
Equity risk is the risk involved in holding equity in a specific investment. When people talk about equity risk, they often refer to equity in companies through purchasing shares of stock but, it can also apply to real estate. When the market value of stocks or real estate drops significantly, that can lead to a massive loss, which is why investors and traders often factor in equity risk before making a move.
5. Horizon Risk
Most investors take a passive approach towards investing and hold securities long-term. However, there are times when your investment horizon may get cut short. For example, if you lose your job or have an unexpected medical expense, you may have to sell some of your investments to get by for the next few months. If the markets are down, you may even end up losing money.
6. Inflation Risk
Inflation jumped by 8.2% this past September compared to a year ago in 2021, which has led to increased prices of goods and services and reduced purchasing power. With inflation, there is a risk that it could outpace the rate of returns on our investments, such as stocks or real estate. Rising inflation dramatically impacts cash investments because the same amount of money now allows you to purchase fewer goods and services than before.
7. Interest Rate Risk
A change in interest rates can affect loans or any debt-related investments. For example, due to rising interest rates and economic uncertainty, housing prices have dropped across the nation, while the housing markets on the West Coast have cooled down significantly. As of October 2022, interest rates have climbed past 6%, which has caused many home buyers to get priced out of the markets and reconsider their home purchase.
8. Liquidity Risk
Depending on the types of investments, there is a chance that you will not be able to sell them when you need the money. That could result from various reasons, such as a lack of sellers, issues with investment platforms, poor market conditions, etc. For example, with crypto lending platforms such as BlockFi, users have complained of experiencing delays when withdrawing crypto. With brokerage firms such as Robinhood, users have complained of withdrawals getting restricted.
Role of Risk
No matter what you invest in, there is always a possibility of losing all your money (plus more if you use margin). However, not all risk is bad. If you manage risk well, it can be an incredibly useful tool.
In an ideal world, we would all invest in securities that have high returns and zero risks. But, the reality is that risk and reward often have an inverse relationship the greater the potential rewards, the greater the risks. For example, back in November 2021, Bitcoin was valued at ~$67,000 per coin. Today, it’s worth about ~$19,000 1/3 of its previous valuation!
Investing successfully involves understanding how much risk you can tolerate and what your risk to reward ratio is. Different investments carry varying levels of risk. It all comes down to mixing and matching different types of investments to fit into your risk tolerance.
Factors That Affect Risk Tolerance
There are three main factors that determine your risk tolerance:
How do you react to bad news? If the market tanks today, are you the type to accumulate dips or sell all your investments? While this is hard to predict until something goes wrong, being aware of your emotions will help you decide the type of investments to make. For example, I had a relatively aggressive portfolio allocation throughout the pandemic, but with growing uncertainty, I’ve taken a more defensive position by accumulating money in a high-yield savings account for emergencies, scaling back on crypto investments, and purchasing I-bonds.
What is the rate of returns needed to reach your financial goals? Understanding what you want to accomplish will help you take the right amount of risk for your needs. That way, you won’t overleverage your positions by taking too much risk or miss out on investment opportunities from not taking enough risk.
How much can you realistically afford to lose? If your investments lost a third of their value next month, would you be able to wait for the market to recover? Many factors can affect your risk capacity, such as your age, financial goals, investing timeline, etc. Because I am in my early 20s, I can afford to make more mistakes and take additional risks knowing that I have time to adjust if things go wrong. However, that may not be the case if you are nearing retirement or have a family that relies on you.
Strategies to Manage Risk
1. Portfolio Diversification and Asset Allocation
The general rule of thumb is to spread your investments across different asset types and industries to reduce risk. By diversifying your investments, you protect the overall value of your investment portfolio. If you have all your investments in one place, you risk losing a significant portion of your capital if something goes wrong.
Diversification also applies to different investments within each investment type. Instead of investing in only tech stocks, I also invest in genomics and healthcare, banking and finance, renewable energy, etc. While my main stock portfolio leans heavily towards tech, I invest in other sectors to offset my losses when tech stocks perform poorly.
In terms of how to diversify, consider your investing style. For day traders or swing traders, diversification is less relevant because of the time in positions. If you are a long-term investor, choosing different types of investment vehicles becomes more crucial as you could be holding these assets for years or decades.
One way investors balance their returns and minimize volatility is to invest in non-correlated assets. That way, when one security is doing poorly, the other is going up.
When deciding asset allocation, note that this is something you should review periodically as your circumstances change. It may be time to rebalance your portfolio if some investments have higher returns than expected while others continue to lag.
2. Balance Portfolio Volatility
While you cannot control how your investments will perform, you can control how much risk you assume. Bonds tend to have relatively low risk, but you won’t see 10x returns on them. Growth stocks and cryptocurrencies can have high returns, but you also expose yourself to a great deal of uncertainty and volatility.
Each asset class will offer different risk to return ratios, and within each asset class, there can be a wide range in the risk versus returns. Generally, bonds, CDs, and high-yield savings accounts have relatively low risk, while stocks, real estate, cryptocurrencies, and commodities carry more risk. However, within the stock market, blue-chip stocks and value stocks tend to be much safer than penny stocks or growth stocks, for example.
Tying back into risk tolerance and diversification, make sure you can stomach the volatility you decide to take on. If you are the type of person to get nervous when stock prices fluctuate dramatically, then stick to safer investments, such as index funds or blue-chip stocks.
3. Hire a Professional
If you have no idea where to start, consider hiring a financial advisor, planner, or coach to help you get set up. Since they are more knowledgeable about different types of investments and how to manage money, they can guide you and provide meaningful advice to steer you in the right direction.
While most financial professionals will not invest on your behalf, they can help you take a more holistic approach to investing and set you up for success. You can also invest in index funds and exchange-traded funds, which are managed by professionals.
4. Establish a Margin of Safety
A popular mantra that many investors and traders like saying is “buy low, sell high.” But, executing this in real life is much harder than it sounds. One way to put this to practice is to create your own margin of safety. For value investors, that could mean only purchasing certain stocks if their market price falls a specific percentage below their intrinsic value.
Let’s say you have a watchlist of ten stocks. You would decide what price points to purchase them at based on your margin of safety. Some investors may use a 10% margin of safety, meaning that if Etsy shares are $100 right now, they will start buying shares if the price falls to around $80.
Because everyone has different risk levels, every investor’s margin of safety may differ. Some investors may set theirs to 20% or 30%, while others may set theirs to 40% or 50%. The greater your margin of safety is, the higher your rate of returns may be and the lower your downside risk.
5. Invest Consistently
If you have a long-term horizon, patience and discipline are key to building wealth. One way to invest consistently is to dollar-cost average into your positions. That means you invest a specific amount of money regularly, such as x amount every week or month, no matter how the markets are doing.
At a previous company, I set up my paychecks to automatically invest 10% into my 401(k). When my paychecks were deposited into my account, I transfer a set amount into my other investment accounts on the same day to ensure that I invest consistently.
While dollar-cost average helps reduce risk, there is no guarantee that you will make money or get protected from potential loss. However, you can reduce the impact of volatility by purchasing investments at different price points.
6. Invest Long Term
Financial markets fluctuate constantly and can rise and fall in short amounts of time. In addition to investing consistently, holding investments long-term can help you get more stable and consistent returns. In the last couple of years, I’ve watched some of my investments fall as quickly as they’ve risen. However, with the power of compound interest, I am certain my investments will net positive down the line.
7. Only Invest What You Can Afford To Lose
If you are a high-risk, high-reward type of person, make sure you only put in money you can afford to lose. As we mentioned earlier, while you can make a lot of money through investing, you can also lose everything.
A few ways to minimize risk are to keep an emergency fund and limit your position sizes on investments. Currently, I hold roughly 1/6th of my money in cash as my emergency fund, but how much you decide to set aside will depend on your circumstances. With any investment, I try to balance how much I invest in any single position.
The Bottom Line Keep Calm and Carry On!
Investing can be intimidating, but all it takes is a bit of financial knowledge and practice to get started. With proper investment risk management, you’ll be well on your way to making consistent and stable returns over time.