Investing is a great way to make some money, but there is no such thing as a safe investment. Each time you put your money somewhere, whether it be in a business, stocks, bonds, real estate, or even your own savings account, you face some type of investment risk. However, not all risks result in a loss of capital, some might only reduce your portfolio value.
It pays to understand the types of investment risk before putting your money to work because it might help you better understand the type of risk you encounter and could prevent you from making a decision that loses you money.
What Is a Loss?
Let’s start with what it means to lose money. A loss is a permanent impairment or loss of capital or an asset. Investment risk is simply the possibility of these real losses. However, do not confuse losses with market volatility, which consists of the daily or even multiyear swings in asset prices. These swings might drop your account value, but if they are not permanent, then they are not true losses. The concern is when prices go low, stay low and are not likely ever to rise to the level when you first invested. This is when the risk of real loss becomes a reality. Below are several types of risk—some can result in a temporary drop in value and some might result in permanent loss of capital.
1. Inflation Risk
Inflation is when prices of goods and services rise due to excess demand. Something that you bought for a lower price in the past than it is worth today is the result of inflation and demonstrates the risk of inflation. Your investments need to grow at the inflation rate or more, because, if they don’t, your purchasing power will drop and you will be able to buy less.
2. Interest Rate Risk
Any interest-bearing asset, like bonds, preferred stock, savings accounts, loans, and REITs faces the interest rate risk. As interest rates change over time, bond prices adjust in the opposite direction. Large changes in interest rates will have a big effect on bond prices. And a move in the wrong direction could lead to a significant loss of principal if the asset is sold or lost if the asset is locked into the long, even multi-decade term.
3. Liquidity Risk
When you have no buyers, it’s impossible to sell. This is known as liquidity risk and is based on how easy it is for you to buy or sell your investment. It is due to the fact that supply and demand drives investment prices. Most often, liquidity risk is low, for investments like funds, stocks, and bonds, though the risk is higher for some other investments like real estate or ownership in a private business. For example, during a housing crisis, it can be almost impossible to sell your house.
4. Concentration Risk
This investment risk can be seen as having too many eggs in one basket. Concentration risk is often seen with employees who only invest in a single fund (like an energy fund or one that only invests in the US) in their 401K plan or exclusively in employee stock options, as opposed to broadly diversified funds, Target Date Funds, or a world stock and bond fund, for example. The antidote to concentration risk is diversification, which is the process of investing in different kinds of assets to reduce the risk of any single investment irreparably damaging your portfolio. Having the bulk of your savings in only one investment can be risky.
5. Market Risk
This type of investment risk affects all investments that are in the same market. By investing in stocks, for example, you face the risks associated with the stock market, and this risk usually shows itself in the form of volatility. Each market has its own unique risks. Diversifying by investing in several different global markets and asset classes can reduce your market risk, but it is really important to remember that market risk and its offspring volatility are unavoidable and just part of investing.
6. Political Risk
When you make investments in different countries, you face different political risks. Your investments can be negatively affected by political action or social upheaval, such as major changes in government (including revolution and civil war), local laws, leadership, or tax incentives.
7. Regulatory Risk
When new regulations or laws are put in place that affect a specific industry or a specific company, you risk taking on losses. For example, regulatory changes in banking are constantly in flux, and this can reduce banks’ profits and ability to earn money.
8. Currency Risk
The exchange rate is constantly changing between nations. And these fluctuations can affect your investment, particularly in global companies and international market funds. For example, if you buy stocks in company that sells goods and services in another country, you could experience huge changes in the exchange rate between the US Dollar and that country’s currency, which can have a significant impact on the value of that stock.
9. Systemic Risk
Systemic risk is the granddaddy of all risks and describes a risk that can bring down a whole market or economy. An example of this would be a collapse of the banking system or several major insurance companies. Insurance is far scarier than banking actually, because insurance companies are interconnected and would likely topple like dominos. The insurance industry also dwarfs the banking sectors in terms of how much assets they manage. Other examples of systemic risk include hyperinflation or civil war or revolution that leads to the complete collapse of an economy. Put plainly and simply, you never want systemic risk.