Risk is a non-negotiable element of investment. While making investment decisions, it is crucial for you as an investor to analyze the risk involved to help you make informed decisions. In this article, we discuss the concept of risk and the various types of risk in investment.
What is a risk?
According to Investopedia, risk, in financial terms, is the chance that an outcome or the actual gains of an investment will differ from an expected outcome or return.
Risk is the likelihood of occurrence of an event i.e. the uncertainty of the actual result of a financial decision.
Types of Investment Risk
Here are 8 types of investment risks that you are likely to encounter:
1. Liquidity Risk
Liquidity risk is the type of risk associated with your inability to sell your investment in exchange for cash or the actual value whenever you want to.
In some cases, to get your money out, you may have to sell your investment at a lower price which often results in losses.
2. Market Risk
This has to do with the instability of prices in the stock exchange market, known as volatility. Historically, the stock market performs very well during the bull run but poorly during the bear run.
This risk is influenced by economic developments or any other occurrence that affects the entire market.
There are three main types of market risk:
- Equity Risk
Equity risk is associated with the drop in price or in the value of shares in the stock exchange market.
- Interest Rate Risk
Interest rate risk is the risk of losing money because of possible falls or changes in interest rates that will affect the value of investments such as bonds.
- Currency Risk
Currency risk is associated with the value or exchange rate of a nation’s currency. Exchange rate fluctuations can affect the value of an investment in foreign currency.
3. Political Risk
The return on investment could be affected by instability in political leadership and activities of a country, especially in terms of policies.
For example, a government might put up a policy to support the activities around a business venture which will attract investors. At the end of the tenure, another leader can decide to change these policies which will affect the business venture negatively and in turn the investment that was earlier made.
4. Inflation Risk
Inflation risk has to do with the possibility that the purchasing power of an investment will not be able to keep up with the rise in the price of commodities. This risk is usually associated with cash or bond investments.
Inflation causes the value of money to decrease over time, whether the money was invested or not.
5. Credit Risk
Credit risk, also called default risk, is a risk that the government, corporation, or debtor might not be able to pay the interest or the principal (borrowed money) upon maturity of the investment.
This is mostly associated with investments such as bonds and other debt securities.
Government bonds tend to have the lowest amount of credit risk but a low return on investment. Corporate bonds tend to have the highest amount of credit risk but with higher interest rates.
6. Concentration Risk
This is a risk of losing money when all your investment is focused on one form of investment.
This risk comes when there is no investment diversification in your portfolio. For instance, if you have all your investment in the stock market, you are taking a concentration risk.
Diversification is the most effective and efficient way to minimize investment risk as it helps to spread your risk over investments across different industries, geographical regions, and companies.
7. Foreign Investment Risk
Foreign investment risk is associated with an investment in a foreign country which may arise as a result of geographical differences, currency risks, political instability, policies, regulations, etc.
8. Business Risk
This is the risk that is associated with the activities of a particular business and how it can affect the value of investments of investors. These activities could be changes in management, employee layoffs, sales or profit margin of the business, etc.
What is Risk Tolerance?
Risk tolerance is the amount of loss an investor is willing and prepared to handle while making an investment decision.
It is an important element of investment that guides an individual on the amount and type of investment they should invest their money in.
There are three types of risk tolerance:
Aggressive
An individual with aggressive risk tolerance tends to be willing to lose all his money on an investment with the potential to make huge returns.
These are huge risk-takers. They generally make huge returns when the market is performing well and huge losses when the market does poorly.
Moderate
Moderate investors can be regarded as balanced investors. They tend to take a little less risk, compared to that an aggressive investor. They have a limit to what they are willing to lose.
Moderate investors often have a portfolio with a balanced ratio of 50-50 or 60-40, with a mixture of stocks and bonds.
Conservative
Conservative investors are willing to take very minimal risk compared to Aggressive and Moderate investors.
They accept little to no volatility in their investment portfolios. These investors often target asset classes with guaranteed returns such as bonds.
Bottom Line
Having read through the different types of investment risks, it is important that you as an individual investor understand these risks and always take deliberate investment decisions.
Building wealth is not easy, we understand this, and that is why we at Cowrywise have always been supportive and committed to helping you grow your finances and build wealth through regular product updates, and helpful blog posts, amongst others.
Take our risk tolerance test, to understand your level of risk tolerance.
