When you’re working to build your wealth, it can be natural to want safe investments with high returns. But the reality is that “safe” and “high return” rarely come as a package deal. Low-risk investments generally produce lower returns than high-risk investments. And while high-risk, speculative investments can produce greater returns, taking on more risk also means you’re more likely to lose some or even all of your money.
Investing is largely a game of risk management. The goal is to take an appropriate level of risk that balances your personal situation with the potential reward you’re trying to achieve. But what exactly do we mean when we talk about investing risks, and what are the different types of risk you should consider?
What are investing risks?
When most people talk about risk in investing, they’re referring to the possibility that an investment will lose money. While that’s not incorrect, it’s also not entirely accurate, either. Overly safe investments can also be risky because inflation can cause them to lose value over time.
According to FINRA (the Financial Industry Regulatory Authority), risk is defined as “any uncertainty with respect to your investments that has the potential to negatively affect your financial welfare.”
In other words, risk is uncertainty. With a high-quality bond, you have a fair amount of certainty about the price you’ll pay for it and how much interest you can expect to be paid back on your money. Stocks, on the other hand, are less certain on any given day. But historically, stocks have tended to produce higher average returns over the long-term. The more risk you take with any investment, the more potential reward you should expect.
Common types of investing risk
While most people understand the difference in the risk they’re taking when they purchase a stock or a bond, there are actually a number of different types of investment risks. This list is by no means exhaustive, but it includes some of the most common types of investment risks.
1. Market risk
This may be the most common risk for investors. It’s simply the risk that the price of stocks, bonds, commodities and other common investments will move day to day — or even minute to minute.
This volatility can be a problem if you’re concerned about short-term price movements. In other words, this is a greater risk if you need to access your investments in the near term. But if you don’t need to access your money right away, you may be willing to take this risk in order to see a potential a greater return over time.
2. Interest rate risk
Interest rate risk is typically paired with market risk. That’s because a change in interest rates can affect the value of bonds: As interest rates rise, the value of bonds decreases and yield increases.
Interest rate risk can be a factor if you’re planning to buy and sell bonds before they reach maturity. It can also impact the price of stocks. However, like market risk, this is typically less of an issue when you plan to hold stocks and bonds for long-term goals, as a longer time horizon tends to smooth out the shorter-term fluctuations.
3. Credit risk
Credit risk refers to the possibility that a borrower might not be able to meet its lending obligations and repay debt. It is also called “default risk.”
If you hold bonds, particularly corporate bonds, you should pay attention to credit risk, because when you purchase a corporate bond, you’re essentially lending a company money to get interest payments in return. As an investor, you should look at factors like cash flow and credit ratings to get a sense of the credit risk a company poses.
The greater the risk that a borrower may default, the higher the interest (known as “coupons” on bonds) you should expect to get in return. However, you’re also weighing this with the higher possibility that the company may default on its debt.
4. Inflation risk
This one is interesting in that it is risk associated with “safe” assets. Inflation risk refers to the possibility that your returns will not keep up with the rate of inflation, which could translate into a loss of purchasing power over time.
Inflation can be a major concern for more conservative investments like cash, cash equivalents and even bonds, which tend to provide lower total returns over time than assets like stocks. Inflation risk is why it can be a good idea to take more risk with money that you don't intend to access in the short term.
5. Liquidity risk
Liquidity risk is a measure of how readily you can convert your assets into cash at a fair price. Generally speaking, cash, cash equivalents, stocks and bonds are all considered to be relatively liquid assets because there is a well-established market for buying and selling them. Hard assets like real estate and collectibles (among others) are often considered to be less liquid (and thus have a higher liquidity risk) because it’s not always easy to quickly convert their value to cash.
It’s typically a good idea to make sure you have enough liquid assets to cover your immediate needs. But if you won’t need your money right away, taking on some liquidity risk can earn you a premium over more-liquid assets and help to grow the value of your money over time.
6. Currency risk
If you hold foreign investments, the performance of those investments will depend in part on the exchange rate between currencies. If an exchange rate were to move rapidly in one direction or another, it could have a major impact on investments you have in that country. This is currency risk, also known as “exchange-rate risk.”
While currency risk can negatively impact investments, the opposite can also be true. This is where a well-diversified portfolio, incorporating both domestic and international investments denominated in foreign currencies, can come into play; being diversified helps you manage shifts in any one currency.
7. Political risk
Political risk refers to the likelihood that an investment’s performance might be influenced by political developments. This can include political instability, unexpected regime changes, unexpected election results, military activities, the introduction of new laws and regulations and more.
While political risk can cause movements in both the broader market and in pockets of the market, this risk may sometimes feel more magnified and relevant than it actually is.
Managing your investing risk
Ultimately, the key to managing investing risk is to build a well-diversified financial plan that is tailored to you. A financial advisor can show you how a range of financial options — including a mix of traditional and nontraditional investments — can help grow your wealth over time while also managing risk.
All investments carry some level of risk including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against loss.