What are the Top Types of Investment Risk?
Investment risk is the chance that an expected outcome or gain will be different than the actual return. Some securities, such as bonds, are considered low-risk investments, while others, such as stocks, are considered high-risk investments. Risk can be reduced through diversification.
What Is an Investment Risk?
Risk is the possibility that an investment will perform differently than anticipated.
According to the U.S. Securities and Exchange Commission, all investments involve some degree of risk.
- How quickly you can access your money when you need it.
- How quickly your money will grow.
- How safe your money will be long term.
Generally, investors take higher risk in exchange for potentially higher rewards.
Some investments are considered riskier than others. For example, certificates of deposit (CDs) are considered low-risk investments because your money grows at a predetermined rate for a specific time.
CDs are bought at a bank or credit union and are insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000.
On the other hand, stocks are considered a high-risk investment. Market volatility and other factors often cause stock values to widely fluctuate. Still, stocks often produce the greatest gains over time when compared to other, lower risk investments.
Risks can be mitigated using different strategies, such as portfolio diversification and asset allocation.
Types of Investment Risk
When you place money in an asset, you assume a level of risk.
However, all risk isn’t created equal. Certain factors may affect a particular asset more than others. You might be able to control or minimize some risks, while others may be out of your control.
- Liquidity Risk
- Being unable to quickly access your money is known as liquidity risk. If you need funds immediately, you are less likely to place your money in volatile investments or assets that cannot be quickly liquidated. If all your funds are tied up in stocks, for example, you may lose money if you are forced to sell shares after losing your job.
- Longevity Risk
- Running out of money after leaving the workforce is a real threat for retirees. This is known as longevity risk. The length of your retirement may be much shorter or longer than your statistical life expectancy. Annuities are often marketed as a hedge against longevity risk because they can provide a fixed stream of income for the rest of your life.
- Interest Rate Risk
- The value of certain assets is tied to interest rates. With these assets, there’s always a risk of losing value because of interest rate fluctuations. Bonds can be especially vulnerable. For example, rising interest rates can make new bonds more appealing because they have a higher rate of interest than older bonds. In contrast, selling an older bond with a lower interest rate may result in less money.
- Inflation is the general increase in prices and fall in the purchasing value of money. Inflation can be risky for investors who receive a fixed rate of interest on an asset, such as an annuity. Inflation is also a concern for investors with large sums of cash. Money sitting idle in a savings account may not earn enough interest to keep pace with rising inflation.
- Market Risk
- Market risk — also known as systematic risk — involves external factors outside your control that may negatively affect your investment returns. It’s difficult to mitigate this risk because it impacts the performance of an entire market simultaneously. Examples of market risk include recessions, central bank announcements, legislative policy decisions, changes in exchange rates, and major fluctuations in the cost of commodities, such as crude oil.
- Time Horizon
- Time is a safeguard against risk. A time horizon is how long you plan to hold an asset. It can range from a few months to decades. Typically, longer time horizons allow you to be more aggressive and invest in higher-risk securities because you have more room to bounce back from market volatility and loss. This gives younger investors an advantage. Many financial experts recommend switching to less risky investments as you near retirement because your time horizon is shorter.
Risk vs. Reward
Investors are often willing to stomach risk because there’s a chance their money will grow. But it can be a gamble.
Generally, low levels of risk are associated with lower potential returns, while high levels of risk are associated with higher potential returns.
For example, CDs are considered low-risk investments. However, standard rates of return often range between roughly 0.3 percent and 0.6 percent each year.
Meanwhile, stocks are often cited as earning a 7 percent to 10 percent return each year on average.
It’s important to evaluate your own personal risk tolerance. Figure out how much uncertainty you are comfortable with in order to chase a desired pay off.
- Investment goals
- Retirement age
Identifying your investment goals — or why you want to invest — can help you figure out which assets to invest in, how much money to allocate and for how long.
Diversifying Your Portfolio and Minimizing Risk
Portfolio diversification is the most common and effective way to minimize investment risk.
You can think of diversification as the old idiom: Don’t put all your eggs in one basket.
In this case, eggs are money and baskets are different assets and investments.
Spreading your portfolio among different investment vehicles — including cash, stocks, CDs, bonds, mutual funds and ETFs — is one way to lower your risk.
Many experts also recommend diversifying your holdings. For example, owning stocks only in the real estate sector could be devastating if a housing crisis arises or a recession halts development.
Likewise, it’s smart to diversify domestic holdings with international assets, and long-term growth opportunities with short-term gains.
Look for assets whose returns haven’t historically moved in the same direction as other investments. If part of your portfolio starts to decline, these other assets will hopefully continue to grow, and vice versa.
Diversification can’t safeguard you against every risk, but it plays a key role in helping you achieve your long-range financial goals — while losing as little money as possible.
8 Cited Research Articles
- Schreier, H. (2020, May 22). Investing Fundamentals For Young Adults: Understanding Risk. Retrieved from https://www.forbes.com/sites/halseyschreier/2020/05/22/investing-fundamentals-for-young-adults-understanding-risk/#c0b8d397058a
- Alvarez, J. (2020, January 19). 5 essential lessons about portfolio diversification. Retrieved from https://www.cnbc.com/2020/01/17/5-essential-lessons-about-portfolio-diversification.html
- National Endowment for Financial Education. (2020). How to Manage Investment Risk. Retrieved from https://www.smartaboutmoney.org/Courses/Money-Basics/Investing/How-to-Manage-Investment-Risk
- Financial Industry Regulatory Authority. (2018, April 3). Investment Risk, Explained. Retrieved from https://www.finra.org/investors/insights/investment-risk
- Pfau, W. (2016, August 23). Three Questions To Evaluate Longevity Risk For Retirees. Retrieved from https://www.forbes.com/sites/wadepfau/2016/08/23/three-questions-to-evaluate-longevity-risk-for-retirees/#1e1dfd21585b
- Financial Industry Regulatory Authority. (n.d.). The Reality of Investment Risk. Retrieved from https://www.finra.org/investors/learn-to-invest/key-investing-concepts/reality-investment-risk
- U.S. Securities and Exchange Commission. (n.d.). Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing. Retrieved from https://www.investor.gov/additional-resources/general-resources/publications-research/info-sheets/beginners-guide-asset
- U.S. Securities and Exchange Commission. (n.d.). What is Risk? Retrieved from https://www.investor.gov/introduction-investing/investing-basics/what-risk