Types of Investment Risk
No matter how you invest your money, you’re taking some form of risk. And there’s not just one or two investment risks – there’s multiple types of risks to consider.
No single investment protects against all types of risk, either. Often when you protect against one form of risk, it exposes you to another.
So the more you know about how the various types of investment risk work, the better you can protect yourself.
Read on to learn how to recognize investing risks, how to decide which are most important to your situation, and how to balance protection against different risks.
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What is Investment Risk?
IN THIS ARTICLE
“Risk” is defined as “exposure to the chance of injury or loss.”
“Investment risk” describes exposure to the chance of loss in terms of how big the deviation is between an investment’s expected return and its actual return.
Technically, the deviation from the expected outcome can be positive or negative, but most investors are concerned with the negative side – specifically, the high degree of risk that could result in loss of capital.
How investment risk works
Often people associate investment risk with the ups and downs of the stock market. But suppose you kept your money in a fireproof, theft-proof vault for ten years. Surely that would keep it safe from risk, right?
Wrong.
Ten years later, you might find you could buy much less with that money due to inflation than when it went into the vault.
Also, in ten years, that money would have made no progress toward growing to meet your future needs. You would have saved your money, but you also lost valuable time.
Those are just some examples of how risk takes on different forms. Risk includes anything that threatens to prevent you from reaching your financial goals, and that could be several things.
You can think of risk as a master of disguise. The key is to recognize it in all its disguises so you can deal with it.
Types of Investment Risk
Understanding these 12 types of investment risk can help you recognize and manage risks more carefully, so you reach your intended financial goals.
Capital risk
Capital risk is the risk of losing money, and it’s usually what first comes to mind for most people when they think about investing risks. It especially refers to permanent losses that you don’t have a chance to regain.
Naturally, all types of investors are averse to permanent losses. They only take capital risk if it is balanced against the potential for gains.
Volatility risk
“Volatility” refers to the ups and downs that naturally happen to market-traded securities. The more extreme these ups and downs are, the more volatility risk you have.
Volatility differs from capital risk in that the downswings are not necessarily permanent. You have a chance to come back from them, but that can take time.
If you have near-term needs, you are especially sensitive to volatility risk. You can’t afford a downswing just when you need your money.
On the other hand, if you have long-term needs, you will be better able to wait out the ups and downs of the market.
Credit risk (default risk)
This risk generally applies to bonds and other forms of debt securities.
Credit risk (or default risk) is the risk that the issuer of the security will not be able to meet its payment obligations.
At the most extreme, this could result in a permanent loss from not getting paid the principal you are owed on a bond.
However, even a partial default on interest payments is damaging because it robs you of some of the return you expected to get on the bond. Plus, any degree of default is likely to hurt the bond’s price.
Horizon risk (duration risk)
Another risk that typically applies to bonds and other fixed-income securities is horizon risk. It stems from the length of time before your securities mature.
Horizon risk (or duration risk) comes in two forms:
- The longer away the maturity date of a bond is, the more its price could swing up and down in response to interest rate changes and other economic developments.
- If you own long-term securities but have short-term spending needs, there is a chance that your security prices might be down when you need to draw on the portfolio.
To some degree, there should be a match between when your securities come due and when your needs will occur.
Regulatory risk / political risk
Many industries are affected by government regulation on things like environmental rules for oil and gas drillers or patent enforcement for drug companies.
Changes to the law that impact an industry also change the business outlook for companies in that industry, and thus could affect the stock prices of those companies.
Political trends can change the regulatory environment for different industries as well. More broadly, political movements in society can affect stocks via boycotts and divestment campaigns.
Investors should be especially aware when investing in companies with controversial practices that regulatory and political forces could work against them.
Concentration risk
Each security is subject to a specific set of risks. The more your portfolio is concentrated in any one security, the more exposed you are to the specific risks of that security.
To put it simply, if a company goes out of business and 2% of your portfolio was in that company’s stock, it’s a small setback. On the other hand, if 50% of your portfolio was in that company’s stock, it’s more like a big disaster hit your portfolio.
Limiting the amount of your portfolio that is in any one security reduces concentration risk.
Market risk
Even if you reduce your exposure to any one security, you’ll still experience the ups and downs that markets go through as a whole.
For example, if you own 50 different stocks, your portfolio is still likely to be down in a bear market. Only owning securities that participate in different types of markets can reduce your exposure to market risk.
Interest rate risk
Interest rates change almost daily, and this can pose a risk to your investments.
This can hurt you in either of two ways:
- Bond prices tend to rise when interest rates go down, and they fall when interest rates rise. So, rising interest rates represent a risk to bonds.
- Interest rate changes can mean earning lower interest rates on your investments. This form of interest rate risk can be thought of as reinvestment rate risk because the more often you have to reinvest your income securities, the more often you’ll be subject to a potential reduction in your interest rate.
Seemingly safe securities like savings accounts and money market accounts are subject to interest rate changes at any time, so they are very exposed to reinvestment risk.
Typically, long-term investors should worry more about the reinvestment aspect of interest rate risk and so should invest in longer term fixed-income securities. Short-term investors should worry more about the volatility aspect and so should invest in shorter term securities.
Liquidity risk
Liquidity risk occurs when there is a mismatch between when money becomes available and when it is needed.
It is something that can cause cash-flow problems for businesses, but it can also happen to individual investors. If you have money tied up in a five-year CD but need to tap into that money in one year, you have a liquidity problem.
Choose your investments with an eye toward making sure money from them will be available when you need it.
Inflation risk
This is the risk that your money will lose purchasing power over time due to rising prices.
Fifty years ago, something that used to cost $1 would cost $6.63 today. So, any investing for the long term should take into account the impact of rising prices.
Foreign investment risk / currency risk
Foreign countries are subject to different economic developments than the United States. In addition to the prices of their securities going up and down, their currencies may rise and fall relative to the value of the U.S. dollar.
This makes foreign investments subject to an additional source of potential risk. On the other hand, those investments can be used to diversify away from risks to the U.S. economy and markets.
Longevity risk
When it comes to retirement planning, living longer than expected is a risk. It means having to fund more years of expenses than you had planned on.
Don’t simply assume an average lifespan when planning for retirement, because roughly half the population will outlive that average. Plan on funding a long life in retirement and you can reduce longevity risk.
Riskless Investments (e.g., FDIC-Insured Accounts)
People often talk about FDIC-insured bank accounts as being risk-free investments.
However, this is an over-simplification.
An FDIC-insured savings account might protect you against volatility and permanent loss, but it could still leave you open to inflation risk, interest rate risk and other risks.
What the above list demonstrates is that investment risk comes in many forms. As a result, no one investment is free of all forms of risk. That means most investors need a portfolio made up of different types of securities to protect against different types of risks that could end up in sub-par returns.
Manage Risks with a Diversified Portfolio
Diversification means spreading your investments among several different securities to reduce the harm that a setback in any one security could do.
There is more to this than owning a lot of securities, though.
For example, you could own dozens of tech stocks; but if there’s a collapse in the tech sector (such as when the dot-com bubble burst), most or all of your portfolio could be at risk.
Don’t think simply in terms of diversifying securities.
What you really need to do is diversify risks.
How to Build a Diversified Portfolio to Manage Risk
Ideally, your portfolio should be constructed of securities that are exposed to a variety of investment risks.
Diversify across asset classes
This starts by owning different asset classes. Different asset classes give you effective diversification because they tend to react differently to economic developments.
- Stocks
- Bonds
- Cash equivalents
- Foreign stocks
- Real estate and other investments
Diversify within asset classes
Then, within each asset class, you want to spread your risks out further.
- Within stocks, your portfolio should be in different sectors of the stock market, spread among things like tech stocks, finance stocks, manufacturing stocks, etc.
- With bonds, you might have different types of issuers. This could include some government securities, some high-grade corporate bonds and possibly some bonds from high-yield or foreign issuers.
Best Ways To Invest Your Money
Your Strategic Approach to Investing
Building a diversified portfolio to manage risk depends on two things:
- Owning securities that give you some protection against different forms of risk.
- Identifying which risks are the biggest threats to your goals so your portfolio can emphasize securities which protect against those risks.
Finding such a variety of securities is easier than it sounds. A variety of brokerage firms offer mutual funds and robo-advisor products that can help even a novice investor build a diversified portfolio quickly and efficiently.
That can help protect you against risk – in a range of different forms – and set you on a path toward growing your wealth and achieving your financial goals.
Frequently Asked Questions
Q: How do I protect my savings if the dollar collapses in the U.S.?
A: Perhaps the reason people have trouble answering this question for you is that there is no complete answer. The U.S. dollar is the world’s leading reserve currency, and major world economies depend greatly on exports to the U.S. So, if the U.S. dollar really did collapse, then to some extent there would be no place to hide financially. However, while it would be difficult to eliminate your exposure to the U.S. dollar, there are some things you can do to somewhat mitigate that risk through diversification.
For example, consider investing some of your savings in commodities. Global commodities like oil and gold are primarily denominated in dollars, so if the value of the dollar went down, the prices of these commodities would be likely to rise. Don’t go overboard, because commodities are themselves subject to substantial risks, but some investment in commodities would not be out of place for diversification purposes.
Another appropriate diversification move might be to make some investments in securities denominated in currencies other than the U.S. dollar.
If the U.S. dollar did collapse, a likely result would be high inflation. You might see savings account and money market rates rise as well, but they’d have trouble keeping up with inflation. U.S. bonds, meanwhile, would be a disaster. In other words, even what are considered safe investments would struggle if the dollar collapsed. So the best you can do is make sure you are well diversified–and beyond that, hope this worst-case scenario never happens.
Q: Is there a middle-ground type of investment between the low interest rate of a CD and the high risk of stocks?
A: Yours is a timely question because the extreme low interest rates of recent years seems to have widened the gulf between deposit accounts and the stock market. While there is no perfect middle-ground investment, you do have some options for bridging the gap to some degree.
According to the FDIC, one-month CDs currently pay an average of just 0.06% in annual interest, and savings accounts have the same average rate as well. This means it is particularly unrewarding to sit on the sidelines if you want to avoid the risk of the stock market. As a consequence, people are relying on stocks more than they normally would, which only serves to drive stock valuations to even riskier heights.
So, what can you do to get a little better return without submitting to the full volatility of the stock market? Some options are listed below.
Limited-risk options
While none of the following is an ideal, best-of-both worlds type of solution, they are ways to get a little bit better return without accepting the full risk of the stock market:
- Look at longer CDs. If you can commit to CD accounts for a little longer, it can make a big impact on how much interest you earn. At 78 basis points, five-year CD rates are currently paying 13 times what one-month CDs yield.
- CD laddering. If you do not want to lock all of your money up for five years, consider a CD ladder – a series of CDs set to mature on different dates. This will allow you to benefit from the higher rates offered by longer-term CDs, while still having some of your money becoming available at regular intervals.
- Shop around for your CDs. It pays to compare rates to find the best CD rates. For five-year CDs, the best CD rates are nearly three times the national average, and for one-year CDs the best CD rates are more than five times the national average.
- Consider high-quality bonds. Longer-term bonds are yielding more than CDs, so if you can put up with some interim volatility, you could own an investment vehicle that will pay you more interest and be guaranteed to pay its full face value upon maturity. Just be sure you focus on high-quality bonds like U.S. Treasuries because corporate bonds would expose you to some of the same economic risks as the stock market.
- An asset allocation approach. Deciding between stocks and lower-risk alternatives is not an all-or-nothing proposition. A blended asset mix with a limited stock allocation could give you some chance at higher returns without taking on full market risk.
Q: Would it be wise to invest in shipping containers in this economy?
A: This type of investment calls to mind famed Fidelity Magellan investor Peter Lynch, who advocated investing in things you see in use every day. There is some merit to this type of common-sense investing, but it should also be noted that Lynch rose to prominence in the late 1970s. This was a time when the stock market was still recovering from an extended bear market, and international investing was still in its infancy. As a result, valuations were much cheaper than they are today.
Now, investors around the world are constantly on the hunt for the next compelling investment story, and that makes things more complicated. A huge amount of money chasing investment opportunities tends to raise the price of investments, attract competition to growth businesses and create opportunities for scam artists. All of this is exacerbated by the low yields on bonds and savings accounts, which have investors desperate for alternatives.
In today’s global economy, there is no doubt that the intermodal transportation of goods that uses shipping containers will be a central part of commerce. So, barring some kind of extended economic slump, you can take demand growth as a given. However, there are some other key questions you have to ask before you assume that shipping containers are a good investment:
- How is supply growth? Demand growth may be steady, but if people are building new shipping containers faster than that demand growth, it will diminish the return on those containers.
- What is the current yield? Promoters of investments like to cite past returns, but what matters to new investors is the current yield. What earnings are shipping containers generating as a percentage of the price it costs to invest in them? Note that this yield not only has to compete with the yield on savings accounts or bonds, but it should offer a substantial premium to compensate for the greater risk.
- Is there a diversified vehicle for investment? The more diversification, the better. This is true for the variety of shipping companies and the range of trading partners in various parts of the world.
- Are the fees for accessing the investment reasonable? Diversification is good, but anyone bundling these opportunities into an investment vehicle is going to be charging a fee. You need to consider how much that will erode the return available.
- Is the provider trustworthy? This is the most important question. Try to make this kind of investment through a reputable bank or brokerage firm regulated in the U.S.
Q: Where I can get a tax-free account with a safe maximum interest rates?
A: As simple as that question may seem, it actually breaks down into three components:
- Setting up a tax-advantaged vehicle
- Defining safety
- Finding the highest interest rates
Here are these three components in depth:
1. Set up an investment vehicle with tax advantages
The best way to approach the tax question is to set up a tax-advantaged vehicle like an individual retirement account (IRA). These allow for a variety of investment products to be used within them, giving you the latitude to choose the product that suits your risk profile and has competitive rates.
Traditional or Roth IRA for tax-free savings?
Within IRAs, you can choose between a traditional and a Roth IRA. The principle difference between the two is that a traditional IRA allows you to defer taxes until you start taking money out of the plan. A Roth IRA requires that you pay taxes up front, but then all your investment earnings and distributions from the account are tax-free.
A major factor in deciding which IRA is right for you is whether you think your tax bracket is likely to be higher now or when you are in retirement. When you are in a relatively low bracket, you can pick the type of IRA that will require you to pay taxes.
As you might gather, these plans are not completely tax free, but they do offer you the opportunity to defer taxes or avoid taxes on investment earnings.
2. Determine which investments are safe
Though several investment products and instruments offer guarantees of principal and interest, the key is to determine who is backing that guarantee. For example, an insurance annuity product may only be as safe as the creditworthiness of the company issuing it.
Are government-backed deposits safe?
Generally, to be completely safe, people opt for investments backed by the U.S. government. This includes Treasury bonds and FDIC-insured deposit accounts.
However, time frame is also a factor. Treasury bonds can fluctuate in value up until the time they mature, so if you have a shorter time frame, this may represent some risk.
Certificates of deposit (CDs) don’t fluctuate in value, but if you need to access your money before maturity you may face a penalty. Again, time frame is a factor in determining what “risk-free” means.
3. Locate the highest interest rates
Once you have determined the risk profile and the time frame that suit you, you can compare rates among products with similar characteristics.
How can you compare interest rates?
For Treasury bonds, this is pretty straightforward – Treasuries with similar maturity dates should have similar yields. For deposit products, you have a wide range of choices and bank rates for savings accounts and CDs vary widely.
It helps to get the question of how you want to define safe investments out of the way before you start comparing interest rates. That definition will narrow down the field, and allow you to make apples-to-apples comparisons of rates among vehicles with essentially the same risk profile.
