Last Updated on 12 April 2021 by Dan
Hello everyone! When you started investing you’ll hear investment writers and professionals talk about risk. What’s a slightly harder question to answer is exactly what risk is, and what types of risks we might actually expose ourselves to when investing! So I thought I’d aim to demystify those in today’s posts.
I’d always encourage investors to bear in mind that where an investment has higher returns, it generally holds higher risk as well – there’s a strong correlation between these two things.
The real secret and challenge of good investment is getting that balance between risk and return in the right place for you, and a financial advisor can really help with this if you’re not confident you can do so yourself.
And on that: Our normal note that we take care with what we write on this site but it is not official “financial advice” and whatever investments and savings you enter for need to be right for you specifically, and we also suggest doing your own further research. If you’re in doubt about anything, it’s worth consulting a regulated and reputable financial advisor who can provide tailored advice built for you.
The Types of Risk
What is Market Risk?
The most common type of risk an investor will be exposed to is market risk. Let’s say we buy a single name stock/equity – in it’s purest form the market risk is that the value of that product may change day by day and it may not be in our favour.
Market risk tends to go hand in hand with volatility – the more a price goes up and down rapidly in it’s recent history the more exposed to market risk we must be because the risk of price change becomes higher.
It’s a little bit more complex than that in reality though, as there are two types of market risk:
There is diversifiable market risk – an example of this where we can reduce market risk through having exposure to a variety of business sectors that do not move in sync. For instance, if we target aviation shares and an event happens which causes flights to temporarily stop, we’re at significant risk vs. a portfolio that combines these investment with something else that may not be affected (let’s say technology.)
And there is undiversifiable market risk – this is a recognition that when the stock market does drop (such as in a market crash) scenario there is some form of correlation between the general direction of all shares, even after we’ve diversified for sectors with different business cycles.
What is Credit Risk?
A credit risk is the risk that when we have given someone our money, they’re unable to give it back. This isn’t generally a risk when in investing in equities, but if you invest in bonds or are making a loan type arrangement such as peer to peer lending it’s something you definitely need to consider.
For publically traded companies you can assess “credit quality” relatively easily by the fact credit rating agencies publish ratings – such as high quality “AAA” or sub-investment grade “CCC” for companies. The lower the credit quality, the higher the risk and therefore with low credit quality you expect achieve a higher return to compensate you for this risk (and would also want to be more cautious).
You can read more about the credit risk side of bonds in our recent article on the differences between investing in bonds and equities.
What is Interest Rate Risk?
Interest rate risk is effectively a form of opportunity cost. What I mean by opportunity cost is where we lose the ability to take what could have been a better course of action when we’re tied into something.
A really easy example is a bank account where we agree to deposit money for 2 years for what at the time is a good fixed rate of interest, and cannot withdraw it without being penalised for doing so. Unexpectedly to us interest rates rise – if we had the money free we could have got a better rate, but instead we’re now stuck in an account giving a lower lever of interest than is available today.
Unless we’re heavily into bond investment, most people are most likely to experience interest rate risks through having a mortgage.
What is Liquidity Risk?
Liquidity Risk is associated with the inability to extract ourselves from an investment position – either through terms and conditions because we cannot find someone to take the other side of the trade.
Let’s take two examples:
In this case, I invest in a FTSE 100 company. These are so frequently traded on the market that even in stressed market conditions I can find someone to sell the stock to at a price reasonably close to market price. This is an example of having very minor liquidity risk.
In the other case, I invest in a very small specialist company on the AIM which is not well known. In a stressed market, there may simply not be someone looking to buy when I am looking to sell – thus I may have to sell at a cheaper price that the even the quoted market price to actually offload the share. This is definitely having liquidity risk!
It’s important to understand where you have and haven’t got liquidity risk – property funds are a good example of where it can crop up as buying and selling property can be a slow and cumbersome process.
The unfortunate recent other prominent example is in Neil Woodford’s funds, where investments were in private companies (I.E not publicly traded on the financial markets) which are much harder to liquidate.
What is Inflation Risk?
We’ve spoken about inflation before in other articles – but just to recap inflation us where prices in general go up. Think of the price of your weekly supermarket shop increasing by a couple of pounds because a few items increase 5/10p each.
Whilst you don’t generally notice it day-to-day (aside maybe through ever shrinking chocolate bars!) it can have a real effect on eroding our finances.
Let’s take a bank account – now most current accounts are only paying 0.5% (if that) at the moment, but the rate of inflation is targeted to be around 2%. This means that because prices are increasing faster than the return we’re getting on our investments, we are effectively losing money in what’s known as “real terms”. That is inflation risk.
What is Concentration Risk?
This is exactly what it sounds like – the risk that we are particularly exposed by focusing on a very narrow sector in the market. It’s near identical to the diversifiable element of market risk noted above (it’s not quite the same, but that’s getting into the more technical end of risk theory).
Let’s say that we’re only invest in technology focused funds and a shock impacts the tech stocks – all of a sudden our portion of the market is hit hard, but others aren’t.
Other Risk Types
This isn’t comprehensive – there are plenty of other risk and sub-risk types out there – these are the most common types that your average investor will be exposed to.
What is your risk tolerance?
We got a guide on the site to understanding your investment risk profile as part of our “Starting to Invest” series. This is designed to help you understand your investment risk profile and how these correspond to the risk associated with different investment products.
If you have any questions on the risks or are looking for more detail just ask in the comments below!
And that’s it!
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