What are the common types of investment risk?
Successful investing rests upon understanding, accepting and managing the various types of risk you could face. This article discusses six types of risk – useful reading for those studying for CII investment-related exams.
This article is correct as at 18 April 2023 – adapted from an article originally written for this site by Mark Underdown – The Wealth Analyst
The most commonly used measure of risk is standard deviation, which is essentially a measure of volatility. This will provide us with a number, but one number will not completely measure all of the risk our clients face as investors. It is therefore important to remember that risk can be a moving target affected by a variety of factors and market pricing.
It’s always useful to remember different types of risk inherent within different types of investments that may not necessarily be reflected in historical volatility measurements.
Inflation is one of the main reasons many clients invest in the stock market.
Whilst keeping funds on deposit in banks and building societies provides security in as much as we can get our capital back at any time, it is very much exposed to the threat of inflation, in particular now when we are experiencing a period of very high inflation.
Although interest rates are increasing, they still remain below the rate of inflation, driving many people to become investors, perhaps even reluctantly.
To achieve potentially higher returns, we have to accept other types of risk.
Every investment carries with it some risk that the original investment amount will not be returned.
At the very basic level, a share in a company has a higher risk of outright capital loss than most fixed-interest investments, but for practical purposes, this type of risk is diversified away through fund management or tracking an index.
Whilst with a well-diversified multi-asset portfolio the likelihood of outright capital loss over a long time horizon is so small that it is practically irrelevant, when we introduce client time spans, it remains an essential part of investment planning.
Whilst a 50-year chart will show that you don’t really have much to worry about when investing, how many people truly have this level of time horizon? We all understand the long-term benefits of investing, yet individuals have both shorter-term mindsets and shorter-term needs. This makes capital risk a very real concern and explains why the measurement of volatility and risk profiling become key factors.This article discusses six types of risk – useful reading for those studying for CII investment-related exams. Click To Tweet
Interest Rate Risk
The rate of interest plays a particularly crucial role in determining the price of fixed-interest investment.
When the Bank of England raised the base rate to 3.5%, the yield on the UK’s 10-year gilt edged lower to 3.2%. If you can obtain a yield of say 4% from a deposit account, why would you accept the risk of capital loss for an investment yielding anything less?
This shows us that movements in interest rates act like gravity on prices when they rise, and a pump on prices when they decline.
The simple inverse relationship, as follows:
Interest rates go UP, bond prices go DOWN
Interest rates go DOWN, bond prices go UP
The importance of liquidity is usually underestimated until it is needed.
Whilst liquidity isn’t such an important issue for large pension funds with very long time spans and measurable cash flow needs, it is a crucial factor for everyday investors, because they are much more dependent on their investment assets for their financial and lifestyle needs (many of which are unpredictable in nature).
Owning a portfolio of securities that have a large market demand and are traded daily is far more liquid than owning one property that can take years to find the right buyer, and months to complete the sale.
With liquidity comes the possibility that you may have to accept a price you do not want, but at least you can accept some price. If you have a truly illiquid investment, you can find yourselves unable to obtain any cash for your asset, at least not when you need.
This can further exacerbate any financial difficulties you are experiencing.
If you invest outside of the UK, you expose yourself to currency risk, i.e. the investment asset may nominally perform well, but the return you receive in sterling is eroded by currency fluctuations.
It’s also worth mentioning that having your finances entirely in one currency also means that you are taking currency risk, at least at the extreme end.
If you have all your assets in a currency that becomes worth considerably less compared to other currencies, then you will have lost a considerable amount of your purchasing power.
If all your expenses are in one particular currency, however, currency risk becomes particularly acute.
Whilst it is clear to see why leverage is appealing to many investors it is important to understand why it can be dangerous.
If you only have savings of, say, £10,000, it’s rather tempting to borrow £90,000 and then invest £100,000 into, say, a property, than it is to only invest with the £10,000. If you obtain a 10% return on £10,000, you only gain £1,000, but if you obtain a 10% return on £100,000, you gain £10,000 – doubling your initial investment.
However leverage not only magnifies gains, it magnifies losses.
A 10% decline on your unleveraged £10,000 investment still leaves you with £9,000 of capital. A 10% decline on your leveraged £100,000, essentially wipes out all of your capital.
Leverage appears to work like magic when it works, but when it doesn’t work out, the consequences are disastrous.
The risk of leverage becomes particularly severe when combined with some of the other risks mentioned, such as illiquidity, rising interest rates and currency fluctuations.
Despite history showing us many examples of leverage-caused financial messes, the attractiveness of magnifying available investment gains indicates that we are likely to repeat the same mistakes.
This isn’t an exhaustive list of the different types of investment risk we face, but should be helpful to illustrate that risk means more than just a number.
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