There are innumerable investing risks, so here is a bluffer’s guide to the main ones.
Next time you consider an investment, make sure you know which of these risks you’re taking, whether you’re comfortable with it – and whether you’re being offered a sufficiently attractive potential reward to compensate.
The presence of these risks does not mean an investment is a bad one. All investments have at least one of these risks.
What matters is whether price is right for the risk, and whether you understand what you’re getting into.
Note: These aren’t textbook definitions of types of investment risk. They’re meant to get the point across quickly to everyone, not stand up in a court of law.
Business risk
Sometimes used to refer to what I call ‘stock specific risk’ below: that is, the specific risks related to one company’s operations. Others use it to describe risks affecting all companies operating in a particular sector. For example, all fishing boats in the same port are affected by periods of bad weather, however skilled their captain or hearty their sailors. I think ‘sector risk’ describes that better.
Currency risk
The risk that comes through changes in the exchange rate between one currency against another. If you invest in European companies and the Euro collapses versus your currency, then your investment will be worth less in local terms when you bring the money back home (unless your funds are hedged, which costs). Similarly, your repayments on a foreign mortgage will rise as your currency weakens. Currency risk can work the other way of course, to your advantage.
Counterparty risk
This is the risk that someone you’ve entered into an agreement with will default or otherwise screw-up. It’s often not immediately apparent when you make the investment. For instance, the fancy Guaranteed Equity Bond your bank sold you might involve contracts underwritten by an American bank you’ve never heard of that goes bust. Don’t laugh – it happened.
Credit risk
Some people don’t pay what they owe. Nor do some companies. Sometimes even countries fail to cough up. If you’re a good credit risk, that means that banks and others think you’ll pay what you owe. If you’re a sub-prime borrower, they may be more concerned – unless you want a mortgage on a shack in a swamp in Florida in 2003-2007. Credit risk is sometimes called default risk.
Inflation
Ever increasing prices is the reason why nobody ever got rich from keeping money under the mattress (except perhaps the makers of mattresses) and the first reason to invest. It’s not just the low but steady inflation we’ve become used to in recent decades – and that you can plan for – that erodes your returns. If you’re very unlucky double-digit inflation comes out of the blue to crush fixed interest savings. Just ask the nearest German centenarian.
Interest rate risk
The risk that the value of your asset – usually a bond, but also to an extent stocks and other securities – will change in response to changes in interest rates. For instance, if you buy a long-dated corporate bond yielding 5% when base rates are 2%, it will very likely (but not inevitably) fall in price if base rates rise to 4%. A new purchaser would probably demand a higher yield (that is, would pay a lower price) to invest in the same corporate bond, given the risk-free rate was now 4%. A related risk is when you put cash in a fixed rate savings account, or take out a fixed rate mortgage. Your fixed rate will be less or more attractive as the base rate changes.
Liquidity risk
Liquidity is a measure of how easy or hard it is to sell an asset. Cash is very liquid; a house is illiquid. Some small company shares can be easy to sell – just log into your online broker and place the order – but if you try to sell more than the cost of a fancy sofa’s worth the price can plunge, which is another risk of poor liquidity. Money tied up for a year in a fixed rate bond is also illiquid, but that’s a given when you invest. You are accepting interest rate risk, and also the risk that you need your money before the term is up.
Management risk
When you invest in an actively managed fund or investment trust, you take on the risk related to the manager’s performance. He or she may do better than the market, or more likely worse. Using index tracker funds gets rid of management risk. The price you pay with a tracker (for most of us well worth it) is you’ve no chance of beating the market.
Market risk
This is the risk you take for simply showing up and investing in a volatile market. The stock market, the property market, even the market for antique hobbyhorses – all move in their own broad trends, which affect all the assets in that market. You can’t reduce market risk when hobbyhorse investing by buying two different hobbyhorses. But you could buy one hobbyhorse and spend the rest of your money on an antique sideboard. Market risk is sometimes called systemic risk – mainly by pompous people like me.
Political risk
There’s a reason why the Russian stock market usually trades on a lower valuation than Western markets, and why London-listed South African companies may seem cheap. The Russians are experts at the appropriation of private property, while South African companies operate in a beautiful country that politically appears to be going backwards.
Regulatory risk
Political risk for Western economies. The risk that politicians or other lawmakers introduce new rules or costs to an industry or sector that hurts your investment. The growing risk that we might see the election of the most left-wing UK government since the 1970s has hit the shares of energy companies, for example.
Stock specific risk
This is the risk that a particular company goes bust, even while the market sails on regardless, leaving your crappy shares in it floating lifeless in the wake. Companies can fall in price or go bust for all kinds of reasons, from fraud to poor management, though it usually amounts to running out of money. This sort of specific risk is also why fund investors (including passive investors) should spread their money between different companies as their portfolio grows. I even think you should keep some cash in different banks, even if your total balance is below the FSCS compensation limit. Assume anything can fail.
Volatility
In simple terms, volatility is the range over which the value of an asset moves over some time, usually a year (technically, the standard deviation over the return rate). If the price moves a lot, it’s a high volatility asset, whereas if it doesn’t go anywhere quickly, it’s low volatility. Low volatility usually seems more attractive, but higher volatility can deliver superior returns to compensate. Diversification can reduce volatility without denting returns to the same degree. It’s worth considering how closely – or not – academic notions of volatility mirror your own concerns as an investor. (Volatility risk has specific meanings, to do with options or currencies, beyond the scope of this article).
Remember, diversification is your best friend when trying to reduce investing risks. To learn more, please read my article for beginners about risk, returns, time, and diversification.
A brilliant taxonomy of financial risks 🙂 As someone with a somewhat darker view of the hazards to Western societies, I’d add a collapse of the financial system risk – ie that the currency your wealth is denominated is gets destroyed. All unbacked currencies of the type we use universally have failed in the past, because we have had to unlink the medium of interchange function from the store of value functions. Just as hyperinflation did for the German currency it can do for us, and likely causes of hyperinflation ahoy are energy crises and resource crises as a reult of the burgeoning middle-class aspirant competing with us for finite world resources. You hedge against that sort of thing with illiquid nonfinancial assets. Your article on the Rothschilds IT describes some of how they do some of that.
“and spend the rest of your money on a vintage bottle of wine to diversify”
but then you would be running a liquidity risk 🙂
I wish more people understood risk. I get really frustrated when people tell me that bonds or gold have no risk.
Investor risk – risk associated with the behaviour of the retail investor?
The Rhino: The risk you mention,is probably the greatest of them all!
An excellent reminder that risk is not just volatility.
Regulatory risk:
An absolute nightmare. Its like storm clouds gathering year on year. At some point there will be a hurricane that may blow your carefully planned future away. Tax grab on SIPP …? tax grab on your ISA. Maybe they government of the day just says your pension is a pension (QROPS).
And what about planning a future with an ISA? That’s a very insular retirement investment. Try taking that to Spain with you when you retire.
It’s enough to make my head spin
AAJ – clueless investor –
This is a great rundown, excellent information and concisely presented. If only my parents didn’t keep their cash under the mattress all those years, I might have actually inherited something….
I think there are a few important risks missing from this list, namely the risk of not achieving your investment goal within a specific timeframe and your ability to cope if you don’t. There’s also the risk that your assumptions are wrong and that past performance really is no guarantee of future performance. I think the massive list of risk contained in every Key Investor Information Document are as about as useful as the warning label on cotton buds. I wouldn’t have bought them if I wasn’t planning on sticking them in my ears!
You’ve missed Intermediary Risk, that your broker/pension provider/p2p company, for all their claims of ring-fenced accounts, is fraudulent and raids your assets. The FCA covers some of this risk, at different levels of cover.
Tax probably comes under political risk.
My impression is that people at times underestimate political risk in the western economies. Case in point: UK’s additional council tax on empty properties, overtly targeted at foreign investors. And if the copper-bottomed sceptered isle is not immune from it, what can be expected from places further south, like Cyprus (which used mainly foreign investors’ money to bail out its banks in 2013)? Take note, RIT 😉
The American market trades at a premium because folks don’t think such capers are likely to be allowed in the land of the free.
I say, at least until Corbyn and his entourage are removed to Labour’s back benches, places like Guernsey and Isle of Man look quite attractive.
Counterparty risk and credit risk are the same.
@ Chris B
I see counterparty risk as a subset of credit risk, the others being direct credit risk (will x repay the money I lent to x?) and contingent credit risk (if I have to call on y, will y repay his guarantee of x’s direct credit risk?).
@ Hospitaller
If you lend to X you take counterparty risk and credit risk on X.
If you’re not comfortable with that, you get a guarantee from Y.
On Y, as guarantor, you also take counterparty and credit risk.
It’s the same. Identical.
A pretty thorough post on risk. For me, you nailed the important ones, which all investors should be aware of. One addition would be ‘sequencing risk’ For long-term investors and retirees especially.
This one really ‘unpacks’ the average rates of return on assets often quoted by fund managers and advisers. You will always be told of the average past investment returns of 5, 10,15 years by advisers. The longer the period used, the less the volatility. The concept is to show a client that short-term price dips are always evened out for the better over the long term.
Unfortunately, this has one major flaw, particularly when applied to a retiree drawing weekly funds from their investment. Should markets fall dramatically at the beginning of the investment, their withdrawals will require greater liquidation of investments to satisfy. Which means fewer shares to participate in the upturn that follows.Therefore withdrawing funds during a downturn eventually exacerbates losses, making the recovery of those funds more difficult.
Hence it is actually when the market falls occur throughout the life of the investment that affects it, thus it is referred to as sequencing risk- what is the sequence of events affecting this investment.