Investment Risk 101

Daniel Penzing
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Find out everything you need to know about the risk of investing.

The nature of risk is something that is considered by everyone involved in every aspect of the investment game. However, not everyone thinks about the intricacies of the investment world, the different forms of risk, what the risks actually mean, and how they impact the world around us. There are different types of risk in the investment world, and it is important for you, as an individual, to be aware of each type. This will make you equipped to make better decisions when it comes to your investment.

Here is a look at the basics when it comes to investment risk.

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Investment risk is the risk of your money not giving you the return that you had expected out of it. This is a real risk in the investment world, even though this is more so the risk of the investor instead of the individual asset or the investment itself. However, when you look at this from the viewpoint of one investment, the risk of the investment not performing the way that you had intended it to looks a lot like the investment itself being risky.

What Is Risk Management in Investing?

Risk management isn’t just about protecting your investment portfolio from damage … it’s about capitalizing on situations to maximize your returns. In fact, you don’t make money without risk, and you must manage your risk factors before you can manage your profit.

In this article, we’ll provide a comprehensive introduction to investment risk factors, some of the most common risks that investors face and ways to manage them, and how you can use risk management skills to strengthen your overall investment strategy.

What Is Risk Management?

Although risk management often feels like an afterthought for many investors, reducing your risk factor can significantly increase the value of your portfolio. When you choose a reliable, secure investment option, you are, in a sense, hedging your investments against the possibility of a loss. In fact, we often refer to investment risk as benchmarks, barriers to entry, and expectations concerning how an investment may work out.

To better understand the concept of risk management, you should be familiar with two distinct risk factors:

  • Specific Risk
  • Systematic Risk

Let’s take a look at each, and then we’ll give you some suggestions for managing risk in your investment portfolio.

Why Are Some Assets Riskier Than Others?

As you may know, asset management is simply the process of investing in assets to maximise return. Most people think of investments in terms of what they will earn after they sell the asset. Pure investing, however, is all about the potential investment returns.

Since we are talking here about investing, then risk means the potential of losing money on an investment. But where does the risk come from? How can you find out what the possible return is before buying?

Every investment is associated with a degree of risk. Some are safer, providing lower returns in exchange for a lower likelihood of those potential losses. Others are riskier, which means that they’re associated with higher returns, but the potential for a loss is higher as well.

However, the important thing to remember about investment risk is that it’s kind of like a tug of war. On one end there’s risk, and on the other, return. The trick is to look for risky-safe investment pairs. Then you can find the right balance to be rewarded accordingly.

Why do some things have more risk than other things? Let’s take a look at one of the most common financial instruments on the planet – stocks. The risk that investors take on stocks is called systematic risk. It’s also called market risk or just plain risk.

The Typical Investment Risk of Different Assets

Choosing between investments is not just about the returns you can expect, but also the expected risk. Risk is defined as the possibility that you will lose some or all of your investment…and while most assets have some level of risk, there is one security you can count on that has zero risk — cash.

When you no longer need the income from your security, you can sell it … at any time without affecting the security…s value. And while you can easily lose the potential income by holding onto your security, you can never lose the principal amount.

Here is a summary of the level of risk of different assets:

High Risk

These assets have the potential for significantly high short-term growth but provide no guarantee of any positive value, or a significant level of income should you need it.

These are common in high-growth and emerging companies and are generally held for a short time.

Medium Risk

These assets have the potential for moderate short-term growth but may or may not provide an income in the short/mid term.

These are common in middle and maturing companies and are generally held for a short time.

— Cash and Cash Equivalents

Trading and Investment Positions in Financial Instruments.

Cash

Cash in an investment refers to the money that you hold in savings accounts, checking accounts, money market accounts, IRA, etc. Cash in an investment account is invested in the market, and although you won’t earn any interest, you can use it to buy stocks and bonds. Cash can be easily liquidated and converted into cash and thus is generally considered to be a low risk investment.

Cash Equivalents

Cash equivalents are different from cash since they are bought with the expectation that they will be converted into something that will earn a profit sooner than a cash account, such as a certificate of deposit (CD). The profit may or may not be accrued in a certain period of time.

— Bonds and Fixed-income Assets

Bonds are the most common fixed-income asset. In fact, when most people think about bonds, they think about government bonds as opposed to investment-grade corporate bonds. Some U.S. Treasury bonds, for example, are considered to be among the safest investments. But bonds are really a broad category of investments that come with many unique benefits.

The first thing to learn about bonds and fixed-income investing is that they don’t all have the same risk profile. The risk profile of a bond is determined by many factors. For example, the credit rating of the issuer can play an important role. In addition, the issuer, the economic climate, and whether a firm is in the process of bankruptcy can all contribute to a higher risk profile in some cases.

But the risk profiles also differ based on the type of bond. For example, U.S. Treasury bonds represent one type of bond. They are very low-risk but also offer a very low yield. Corporate bonds, on the other hand, are a higher-risk option. But they generally come with a higher yield, meaning that you may earn more based on risk. Using a yield to maturity measure can help you select the right bonds based on risk and money-making potential.

— ETFs and Mutual Funds

You should consider ETFs and mutual funds when you are looking for a low risk investment.

In these low-risk funds, your money is pooled with other people’s money. If it’s an index fund, then you are invested in a certain stock market index. If it’s a mutual fund, then you are invested in a particular group of stocks that matches the mutual fund’s mission statement.

This moves the risk off of the investor and onto the people who chose which companies are in that market index or which companies are in that mutual fund.

The only investment risk that remains is that the managers of the index or the stocks themselves will do something stupid.

— Individual Stocks

Vs. Mutual Funds

There are two basic ways to invest your money:

{1}. Invest in individual companies called stocks.
{2}. Invest in a mutual fund of stocks.

It’s important that you understand the differences between stocks and mutual funds and how to decide which is right for you.

STOCKS

Stocks are shares of ownership in a company. For example, if you buy shares of IBM, you legally become a part owner in the company. Stocks rise and fall in value.

A company has issued stock when it needs to raise money by selling part of its business. When you buy a stock, you are buying a piece of that company.

There are three types of stocks:

OPEN-ENDED FUNDS

Open-ended funds are also called mutual funds. They are baskets of stocks and other instruments, such as bonds. Unlike closed-end funds, which have a fixed number of shares, open-ended mutual funds add more shares when more money is invested and reduce the number of shares when money is withdrawn.

An Open-ended fund is a basket of stocks and other instruments such as bonds managed by a professional investment company. Whereas a closed-end fund, which has a fixed number of shares, opens and closes according to the supply and demand of the stock exchange.

— Options

— Penny Stocks

— Futures

A future is a contract for delivery of a commodity at a specified time in the future. In the over-the-counter markets, futures contracts are standardized by exchange and signed by both parties. These standardized futures are traded on an exchange and are subject to the rules and regulations of the exchange. Investors generally find futures contracts less expensive to trade than stocks.

There are several futures contracts that trade on the exchange, and some of the popular ones include:

  • 1] Soybean Futures
  • 2] Live Cattle Futures
  • 3] Treasury Bond Futures
  • 4] DJIA Futures
  • 5] Euro Dollar Futures

ETFs work similar to an index fund, but they also include a type of derivative called a futures contract. In the ETF, the futures contracts trade in a portfolio, like a traditional stock. The futures contract is attached to the underlying asset. ETFs are a relatively new way to trade futures. The first one, called the Wisdom Tree U.S. Dollar Hedge ETF, started trading in 2006. A new type of ETF, options on ETFs, and many of these ETFs have not survived.

One advantage of ETFs over other derivatives is that they are listed on a major exchange. This makes them liquid, which is a major advantage over options. Options and derivatives can be highly risky, so be careful.

— Forex

Is a very risky investment because of the possibility of all your funds being lost at any time and that "buy and hold" strategy do not really work here as most do not understand the elementary theories behind this new market.

Understand and Assess Your Investment Risk Tolerance

What do I mean by your investment risk tolerance factor? Well, it is getting to know yourself and being honest about your strengths and weaknesses, including how you would react in unprecedented situations, like a market crash.

Your position during the following financial crisis of 2008 and 2009 may having been different due to your level of risk tolerance. Understanding how you would react could have served you very well in the midst of that crisis. Now I know that was a severe crisis but in not so severe situations perhaps you saw a wealth opportunity and took a risk by moving some of your investments into that opportunity.

In either case, your level of risk tolerance is very important in the game of investing.

You need to be continually on the watch to know your tolerance level, being honest with it and yourself. Sure, we have all made mistakes along the way and they make us stronger but if you are not paying attention you are going to make costly mistakes.

Common Risk Indicators and Metrics

Metrics: Some metrics that you need to look at before the next round of investment in a business are:

  • Operating and growth metrics
  • Capital expenditure for investment
  • Capital expenditure for expansion
  • Capital expenditure for risk management
  • Capital expenditure for cost management

Projections: Some basic projections that you need to take in mind while looking at expansion are:

  • Underlying measures of each facility
  • What margin improvement the customer is likely to gain
  • How much up-selling and cross-selling will happen
  • Upside opportunities and assignments

Performance Metrics: Some sub-metrics that you need to take in account while looking at risk management are:

  • Market conditions
  • Cost of services
  • Up-selling opportunities
  • First-time ask for cross-sells
  • Profit sharings
  • Residential and commercial mortgage rates

In general, risk has a connotation that something terrible might happen in future, so it becomes a bad word for investors. But if you analyze the risk carefully it can be used as an enhancement for return on investment.

Manage Your Investment Risk

The goal for most people who invest is to make money. Unfortunately, a lot of investors get frustrated when they don’t see the returns they hoped for, and they don’t realize what they can do to manage their risks and improve their returns.

Your investment risk levels are determined by the amount of money that you’re willing to lose. So the more risk you take on, the more aggressively you should seek potential rewards. Most people don’t take a risk with their investment portfolios because they don’t know how to manage the risks. It’s not about avoiding all risk (you can’t avoid all investment risks), but it’s about planning for it and managing your risk effectively.

If you’re managing your money properly and you’re making safe, conservative investments, then you won’t be disappointed with the returns you get. If you don’t have enough money to start with, don’t take too big of a risk (sell stocks and invest in bonds) or look for another way to earn more money.