Types of Investment Risk - A Universal Guide
KEY POINTS
Your portfolio is always exposed to investment risk; after all, even cash is subject to inflation risk
An understanding of the various types of risks, systematic and unsystematic, is essential when building a portfolio tailored to your risk tolerance and goals
Your investment time horizon has a direct impact on your risk tolerance
Investment Risk Series
This is the first article in a 3 part series. We invite you to read the complimentary articles How to Measure Investment Risk and How to Reduce Investment Risk.
What is investment risk?
It has been defined in various ways including the risk of loss, the potential to incur losses relative to expected returns, and the probability or uncertainty of losses from an investment.
There are many definitions.
To wrap our head around the complex concept of investment risk, I recommend we review one statistical risk measurement tool and then dive into the various types of investment risk.
Do not worry, we are not going to get into any statistical theory, discussions, or calculations. We will save that for another post.
For now, let’s talk about beta and systematic risk.
Beta
Beta is a statistical method utilized to measure volatility (i.e., systematic risk). The market (e.g., S&P 500) includes all systematic risks and has a beta set to 1.0. An individual security with a beta greater than 1.0 is more volatile than the market and those with a beta less than 1.0 are less volatile than the market.
Let’s look at a random sample of securities and their respective betas to gain some perspective. The following betas were accurate at the time of this writing and are subject to change:
Beta has several limitations. Most notably, it only measures the volatility of share prices. It does not account for risks specific to an asset class, industry, or security. We must consider risks that are systematic and unsystematic.
What are systematic and unsystematic risks?
Systematic risks are non-specific (e.g., interest rates, inflation), affect the entire market, and cannot be reduced through diversification. However, such risks may be mitigated through hedging.
Unsystematic risks are specific (e.g., credit/default, liquidity, legal, regulatory, concentration), do not affect the entire market, and can be reduced through diversification.
A more thorough explanation of some of the common systematic and unsystematic risks will provide a more robust understanding of what investment risk is and how it impacts your specific situation.
Interest Rate Risk
A country’s central bank is responsible for developing and implementing monetary policy. Such includes setting the interest rate payable by banks to meet their short-term borrowing needs. The ultimate interest rates applicable to mortgages, government bonds, corporate bonds, and other credit instruments are a combination of the central bank rate and market forces.
Generally, the price of a fixed income security moves inversely to changes in interest rates. When interest rates increase, the value of the fixed income security falls as its future cash flows are discounted at a higher discount rate. Such works in reverse when interest rates decrease.
A change in interest rates will primarily impact fixed income securities, real estate, private equity, and derivatives (e.g., warrants, options, futures).
Currency Risk
If you hold any assets or liabilities denominated in foreign currencies, you are exposed to currency risk due to fluctuating exchange rates. Your investments will increase in value if the foreign currency strengthens and decrease in value if the foreign currency weakens.
Securities denominated in your local currency may also expose you to currency risk. For example, you may own shares in a multi-national corporation based in your country. Such company will have sales in foreign countries settling in the respective foreign currencies.
Forex fees can be substantial when converting currencies. Company’s like Wise provide very cost efficient ways to reduce your foreign currency conversion costs.
Inflation Risk
Your purchasing power decreases as inflation increases. This has a profound impact on fixed income securities as their future principal and interest payments become less valuable. Other asset classes may be able to mitigate the impact of inflation. For example, corporations (i.e., equities) may be able to pass the impact of inflation related to wages and materials to their customers.
Geopolitical Risk
Actual, perceived, or threatened international political conflict can increase market volatility. Such risks include, but are not limited to, war, rumors of war, terrorism, expropriation of assets, trade embargos, regulatory gridlock, human rights violations, and pandemic related travel restrictions.
Credit / Default Risk
There are several ratings agencies (e.g., Moody's Investor Service, Standard & Poor's Global Ratings, and Fitch Ratings) that rate government and corporate lenders. The ratings issued have a direct impact on the price of the respective securities. Therefore, any change in rating (positive or negative) will have an immediate impact on the value of your respective fixed income security.
Credit risk is critically important when considering an investment in fixed income.
For example, emerging market bonds may provide a yield 4% greater than that of U.S. bonds with comparable terms. The emerging market bond is preferable from a pure return perspective. However, the higher yield is largely due to its increased credit risk. Investors must weigh the additional risk assumed to obtain the incremental return benefit.
Counterparty Risk
Counterparty risk is a sub-set of credit risk.
It takes at least two counterparties to enter into a contract. Counterparties are required for derivative contracts. Such contracts may hedge against foreign exchange fluctuations, interest rates, equities, commodities, and more.
An investor and an investment bank may take opposite sides of a given contract. The investment bank represents a counterparty risk to the investor and vice versa.
Liquidity Risk
You may experience liquidity risk if your cash flow is unable to service your liabilities and basic needs. Such can be fueled by liquidity risk associated with your investment portfolio.
You may not be able to sell certain investments in a timely manner due to the structural or contractual nature of the asset (e.g. real estate, private equity, hedge fund). Other investments may be thinly traded on their respective exchanges. A forced sale under either circumstance could initiate substantial price declines and realized losses.
Such liquidity risks can lead to opportunity risk.
Opportunity Risk
You should review your portfolio with your financial advisor on a regular basis and rebalance it, as necessary. Ideally, such process will incorporate all your liquidity requirements.
Unfortunately, new opportunities arise on their own timetable. They may require quick decisions and timely funding. Any liquidity risks described above could result in you not being able to take advantage of investments with preferrable risk-return profiles.
Information Risk
In theory, asset prices reflect all available information. However, such is not always the case. The potential for information risk generally increases as an investment becomes less widely held.
You need access to a broad information spectrum for all types of asset classes. This may require engaging various professional advisors. There are many types of financial advisors. You should carefully choose your financial advisory team to ensure your needs are always met.
You can take steps to perform your own additional due diligence on privately held investments like hedge funds as described in our post Hedge Fund Due Diligence - 5 Steps to Reduce Your Risk. Such steps can have broader application across multiple types of asset classes.
However, information related to specific markets like local residential real estate may be scarcer. You may need to local experts to assist in the due diligence and purchase process (e.g., home inspector, lawyer).
Information risk may be mitigated with adequate time, resources, and expertise. However, such delays may lead to increased opportunity risk (see above).
Execution Risk
Once a decision to trade (buy or sell) has been made, such instructions must be executed. There is a risk of executing the trade at a price different than desired.
The trading of publicly traded securities can experience execution risk due to, but not limited to, poor broker performance, news announcements, market momentum, and your trade order impact on daily trading volume of a thinly traded security.
Concentration Risk
You have concentration risk if the potential loss from a single asset or group of related assets would have a significant impact on your portfolio.
The demise of Enron Corporation (“Enron”) is an excellent example of concentration risk. Enron employees were invested in the company through their employment, Enron stock held in the company pension plan and their personal brokerage accounts, and some employees held Enron stock options. Their wealth was decimated when the Enron stock price collapsed.
Concentration risk can also be experienced at the asset class or industry level. For example, an 80% allocation to cruise line stocks would have had a substantial negative impact on your portfolio during the pandemic lockdowns.
Business and Financial Risk
An individual company will be impacted by many unsystematic risks, in addition to the risks referenced above. Such risks may include strategic vision, management, regulatory, liability, competition (new and existing), cybersecurity, business interruption, reputational, environmental, human resources, unions, research and development, cash flow, and many more.
If you own an operating company, you are familiar with these risks and are accustomed to mitigating them on a daily basis.
When it comes to your investment portfolio, you can mitigate these risks through diversification across asset classes, industries, and individual securities.
Risk, Return, Time Horizons, and Liquidity
Your financial advisor can be an invaluable resource when applying the concept of risk to your investment plan and related decision-making process.
A key investment premise is that investors are willing to accept higher degrees of risk for higher potential returns. For example, let’s consider three bonds listed in order of descending risk: emerging market, U.S. blue chip corporate, and U.S. government. An investor would expect highest returns from the emerging market bond and the lowest returns from the U.S. government bond.
The investment time horizon is a critical component to investment plan. An individual investor may have multiple time horizons (e.g., 5 years for wedding, 10 years for downpayment on house, 40 years for retirement). Generally, short time horizons require lower levels of risk and longer time horizons can accommodate higher levels of risk. This is because a short time horizon does not provide sufficient time to overcome greater than expected losses due to excess volatility. Whereas, a longer time horizon can accommodate a degree of higher volatility and still meet the investment goals.
The investments allocated to each time horizon will need an appropriate degree of liquidity risk. It would be unwise to invest savings earmarked for your wedding into a private equity fund with a lock-up term that extends beyond your planned wedding date.
Bottom Line
The list of risks is extensive, and it is possible for one risk to trigger another. We recommend you choose an appropriate advisory team to ensure your risks are mitigated and your financial goals are met while maintaining an acceptable level of risk.
