The different types of investment risks
No investment is without risk. Even those ‘right thing’ investments that financial advisors push down your throat come with risk.
Unfortunately, to build wealth over time, investors need to accept a significant amount of risk.
Leaving money in risk-free investments such as high-yielding savings accounts just isn’t investing.
In fact, it’s a sure-fire way to lose money due to the rising costs of goods that you’ll buy with that money.
If growing your wealth and financial security is an important goal for you, you’ll need to consider riskier investments than savings accounts. Furthermore, to evaluate an investment, you should consider the different types of risk that could affect its performance. This will help determine whether it’s an appropriate investment for you. So let’s discuss the various types of risk that you’re likely to encounter on your journey.
Market risk
Market risks, or systematic risks, are the price of admission to play in the global market. They consider the broader picture. This is the risk of investments declining in value because of economic developments or other circumstances that affect the entire market. These kind of risks are extremely difficult to control or predict and, as a result, cannot simply be diversified away. The three main types of this risk are equity, interest rate and currency risk.
Equity risk: This applies to any investment in shares and is the risk of loss resulting from a drop in the market price of shares. The market price of shares varies all of the time according to demand and supply.
Interest rate risk: This is the risk of losing money because of a change in interest rate. If the interest rate rises, the market value of bonds will drop. This kind of risk is particularly relevant to the South African property market with the country’s shaky interest rates.
Currency risk: A risk that applies when you own foreign investments. It’s the risk of losing money because of a movement in the exchange rate. If you have an investment in the UK, for example, you may have taken a hit on the result of the Brexit referendum.
Default risk
If you invest in something, a company for example, then you generally expect a return on the investment over time. The promised return will likely be higher than from a standard savings account but you face a risk. Say the company you’ve invested in goes belly up and they can’t pay out your investment. This is the risk of default and is related to the quality of the underlying investment you were promised. Default risk is easily combated through diversification.
Inflation risk
Financial planners work with the understanding that inflation in South Africa runs between four and six percent. This allows them to calculate a potential investment’s expected real returns. But what happens when prices rise at a sharper rate than inflation? Inflation risk is a risk of a loss in your purchasing power because the value of your investments doesn’t keep up with inflation. Inflation erodes the purchasing power of money over time, since the same amount of money will buy fewer good and services. This kind of risk is particularly relevant if you own cash or debt investments such as bonds, while shares are far more resilient.
Reinvestment risk
This is a risk of loss from having to reinvest principal capital or income at a lower rate. Suppose you buy a bond paying 10%. Reinvestment risk will affect you if the interest rates drop and you have to reinvest the regular interest payments at a lower rate than previously. This risk is avoidable simply by spending the regular interest payments or the principal once the investment comes to maturity.
Mortality risk
Consider this risk when you have or are considering investments in things like pensions, insurance contracts, annuities or any investment with a long-term outlook. Annuities are the best example. If your annuity payments continue only as long as you’re alive, then you run the risk of dying before you receive enough of your benefit to make the monthly premiums worthwhile. If your investment strategy is too focused on the long-term, then there’s a chance that you won’t be around to enjoy the benefits.
Life is short. Possibly shorter than you’d want it to be. Spend some time thinking about the risks of your investments. With the help of some reflection and some key financial planning tools, you may find that your tolerance for risk is higher than you expect and that you can adjust your investments to accept more risk in the hope of gaining more reward. The clichéd phrase: ‘You’ve got to risk it for the biscuit’ has never been more relevant.