All investments involve some degree of risk.
In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision.
In general, as investment risks rise, investors seek higher returns to compensate themselves for taking such risks.
Every saving and investment product has different risks and returns.
Differences include:
- how readily investors can get their money when they need it,
- how fast their money will grow, and
- how safe their money will be.
Number of risks which investors face
- Business Risk
- Volatility Risk
- Inflation Risk
- Interest Rate Risk
- Liquidity Risk
Business Risk : With a stock, you are purchasing a piece of ownership in a company. With a bond, you are loaning money to a company. Returns from both of these investments require that that the company stays in business. If a company goes bankrupt and its assets are liquidated, common stockholders are the last in line to share in the proceeds. If there are assets, the company’s bondholders will be paid first, then holders of preferred stock.
Volatility Risk : Even when companies aren’t in danger of failing, their stock price may fluctuate up or down. Large company stocks as a group, for example, have lost money on average about one out of every three years. Market fluctuations can be unnerving to some investors. A stock’s price can be affected by factors inside the company, such as a faulty product, or by events the company has no control over, such as political or market events.
Inflation Risk : Inflation is a general upward movement of prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest. The principal concern for individuals investing in cash equivalents is that inflation will erode returns.
Interest Rate Risk : Interest rate changes can affect a bond’s value. If bonds are held to maturity the investor will receive the face value, plus interest. If sold before maturity, the bond may be worth more or less than the face value. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones. To sell an older bond with a lower interest rate, you might have to sell it at a discount.
Liquidity Risk : This refers to the risk that investors won’t find a market for their securities, potentially preventing them from buying or selling when they want. This can be the case with the more complicated investment products. It may also be the case with products that charge a penalty for early withdrawal or liquidation such as a certificate of deposit (CD).
Inflation Risk : Inflation is a general upward movement of prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest. The principal concern for individuals investing in cash equivalents is that inflation will erode returns.
Interest Rate Risk : Interest rate changes can affect a bond’s value. If bonds are held to maturity the investor will receive the face value, plus interest. If sold before maturity, the bond may be worth more or less than the face value. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones. To sell an older bond with a lower interest rate, you might have to sell it at a discount.
Liquidity Risk : This refers to the risk that investors won’t find a market for their securities, potentially preventing them from buying or selling when they want. This can be the case with the more complicated investment products. It may also be the case with products that charge a penalty for early withdrawal or liquidation such as a certificate of deposit (CD).
Managing your investment risk
While you cannot avoid investment risk altogether, you can manage it and take steps to minimize your exposure.
One of the best ways to manage your risk is to diversify your investments. Both business and market risks can be mitigated to a certain extent by diversification -- not just at the product or sector level, but also in terms of region (domestic and foreign) and length of holding periods (short- and long-term).
You can spread your international risk by diversifying your investments over several different countries or regions.
On top of that, you can manage your risk by doing your homework. Learn about the forces that can impact your investment. Stay abreast of global economic trends and developments.
If you are considering investing in a particular sector, read about the future of that industry. If you are considering investing in a particular country, be sure you understand the local market and political situation.
Finally, consider your options and your own risk tolerance.
Some investment products are more volatile and vulnerable to market risks than others. And some sectors and businesses face more business risks that others.
