An essential aspect of investing is understanding the types of investment risk and the best procedures to minimize the adverse effects on a portfolio. The reason we want to explore the different kinds of risk is that we want to avoid the ultimate risk – a permanent loss of your capital. That is why every investor that accepts risk should have an investment risk management plan.
It is a given that an investor must take a risk to achieve rates of return above a risk-free rate of return. As the risk-free rate of return is virtually zero, most investors are being forced to accept the risk to achieve their long term goals.
What Is Investment Risk?
Most of us think of risk as negative. We are going to encourage you to feel a little differently about it. Risk is a deviation of an expected outcome. In investing, we can look at risk as a deviation of expected investment returns.The deviation from the expected return can be either positive or negative. The probability and magnitude of the variance are what concerned an investor. Many factors can affect risk, and there are portfolio management tools to measure and mitigate the risk factors. Understanding the types of investment risk allows an investor to manage risk and optimize outcomes. Let’s look at the different types of investment risk and how a portfolio manager can use the tools available to improve their probability of positive outcomes instead of negative outcomes.
Market risk, also known as systematic risk, is risk affiliated with market returns. These can include macroeconomic factors such as interest rates, inflation, recessions, currencies, politics, etc.
In the short term, stock market prices cannot be predicted. But long term returns can be predicted with some accuracy. In other words, the variation of returns (risk) is less over long periods than short periods.
Long term market returns are inversely correlated with valuations. This is why investors should use a tactical asset allocation, which invests more in assets when they are selling at bargain prices and less aggressively when estimates are high. A long term investment horizon, together with an active asset allocation strategy allows an investor to mitigate market risk partially.
Specific risk, also known as unsystematic risk, is risk that is not correlated with market returns. It is the risk that is specific to a particular company or industry. An individual investment, such as a company, can have problems that are specific to that asset. Maybe a catastrophe (i.e., BP oil spill), bad management, a massive product failure, etc. causes the individual assets price to fall. The good news is, specific risk can be virtually eliminated by diversification.
This may be the least understood and most underrated of the different types of investment risk. Did you know two different portfolios can have identical average returns but provide very different total returns? The more volatile the portfolio, the lower the total return.
Very few investors match the advertised “average return” of a market index or fund because portfolio volatility eats away at your portfolio value. It could be costing you a large portion of your retirement.
For example, if you have a negative 50% return and a positive 50% return, you have an “average” return of 0%. But you have lost 25% of your portfolio! Very few investors realize how much their portfolio value is being affected by portfolio volatility.
When interest rates rise, the price of bonds decline. Interest rates also affect economic activity and borrowing costs.
Sometimes a borrower is unable to pay back debts or bills.
Higher prices lower the purchasing power of your investments. If your investment returns don’t exceed inflation, you are losing purchasing power.
Economic recessions and depressions can have profound effects on asset valuations.
Let’s assume that many years ago you bought a Treasury Bond paying 8% that is maturing. Now the interest rate is less than 3%. If you reinvest, it will have to be at a much lower rate.
If you need to sell an investment, you may not be able to find a buyer promptly. Most publicly traded equity and bonds are relatively liquid. But many alternative investments such as real estate, artwork, coins, stamps, etc. may experience periods when they are illiquid.
Governments have a significant effect on social stability and the economic environment for investment. Look for political stability and business-friendly policies.
Asia Alpha Capital Management does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any investment decision without first consulting his or her own financial advisor and conducting his or her own research and due diligence. To the maximum extent permitted by law, Asia Alpha Capital Management disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses.
Content contained on or made available through the website is not intended to and does not constitute legal advice or investment advice and no attorney-client relationship is formed. Your use of the information on the website or materials linked from the Web is at your own risk.