All investors should have an awareness of risk, but how many actually understand risk and the different types of risk that can come along with investing.
This blog is designed to give you a basic summary of all the different types of investment risk and highlights the importance of diversification within a portfolio of investments.
What is risk?
Everyone knows what risk is, in the simplest terms, risk is the possibility of something bad happening.
Investment risk is no different. Investment risk is defined as the probability or likelihood of losses relative to the expected return on any particular investment. This includes the possibility of losing some or all of an original investment.
Risk is an unavoidable part of the investment process, even so called ‘risk free’ investments are still exposed to a degree of risk.
Most investors simply think of risk in terms of their investment moving up and down in line with the stock markets, i.e. the market crashes for whatever reason, then the investment goes down. We all saw this earlier this year at the height of the Covid-19 outbreak.
However, in actual fact, this is only one type of investment risk. Investment risk can be split into many different types of risk.
The main two types of risk in investing are market risk and investment specific risk.
Market Risk
Market risk is also referred to as systematic risk. This is the risk that affects the markets as a whole and cannot be avoided.
This is the risk that the stock markets will go down (or in some cases ‘crash’) as a result of news or events, such as terrorist attacks, global pandemics (as we are all now very well aware), changes of government or changes imposed by governments (such as tax changes), changes in interest rates, inflation or other general changes in the economy.
Investment Specific Risk
This is also known as non-systematic risk. This is the risk specific to a particular company or investment and can be described as news or events that are specific to that particular company which is unrelated to the systematic risks described above. Examples of this type of risk include, technology breakthroughs which may make a product obsolete or a new competitor coming to the market offering the same product/service etc for potentially more competitive cost.
This can be avoided or diversified away by for example, including investments with multiple companies so that if the investment in one goes down, this will only be a smaller part of a portfolio of investments compared to having 100% of an investment in one company.
Other types of risk include the following;
Inflation Risk
Inflation risk is the risk that inflation will undermine an investment’s returns through a decline in purchasing power. Bonds and cash are most subject to inflation risk.
You may think that cash is a risk free investment however if inflation is higher than the interest rate then the real value of the cash is eroded as it will now buy less than it would have at the time of the deposit.
The best way to avoid inflation risk is by investing in ‘real assets’ such as equities, property etc, which are known to beat inflation over the long term, keeping only the necessary emergency funds in cash so that these are easily accessible.
Interest Rate Risk
Interest rate risk is the potential for investment losses that result from a change in interest rates. If interest rates rise, the value of a bond or other fixed-income investment will decline, and if they fall, the value goes up.
Changes in interest rates can be caused by the general economic cycle (booms, recessions) and government fiscal and monetary policy.
This type of risk can be reduced by investing in shorter duration bonds or in cash.
Credit Risk
Credit Risk mainly affects bonds. This is the risk that the bond issuer will fail (default) to meet their obligations to pay interest payments or return the capital invested. This can happen if the institution issuing the bond gets into financial difficulty or has its credit rating downgraded.
This can be avoided by investing in government issued bonds which are generally secure as they are government backed or by diversifying bond holdings as with investment specific risk, so that losses from one will not affect the others.
Currency Risk
Currency risk is the possibility of losing money due to unfavourable moves in exchange rates.
Investments that operate in overseas markets are exposed to currency risk. For example, if a UK based investor invests in a US Equity fund and Sterling strengthens against the Dollar. This erodes the real value of the Dollar dividends paid into the fund. If Sterling falls, the overseas investment tends to rise.
This can be diversified away by investing in a range different world markets, as not all currencies move in the same way at the same time.
Liquidity Risk
Liquidity is how easily an asset or security can be bought or sold in the market, and converted to cash.
Property is one of the most illiquid investments, how easy is it to release funds if needed if they are tied up in property? Again, diversification of investments can help with this type of risk.
Event Risk
Event risk refers to any unforeseen or unexpected event that can cause losses for investors in a company or investment. This links into market risk, investment specific risk and credit (default risk). For example if a company is unable to pay interest/dividends or return the capital invested due to a specific event (credit risk), either due to a global event such as terrorist attacks or war (market risk), or due to a specific event within a company (investment specific risk).
This can include events such as an industrial disaster such as oil spills. Event risk also incorporates the ‘acts of god’ events such as hurricanes, earthquakes etc.
As with market risk, certain events cannot be diversified away but for the more company or even industry specific risk, a well diversified portfolio can help with these elements of risk.
Political Risk
This is the risk that Governments (or potentially new governments in the lead up to an election) will change monetary or fiscal policies, such as increasing taxation.
However global political risk is also a contributor to the risk and volatility of UK investors.
For example, have you checked the stock markets (like the FTSE 100) lately? How many times do you see an article starting with ‘FTSE down (or up) as Donald Trump says… well ‘something controversial’?
Operational Risk
Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, systems or external events.
This includes the risk of the transaction failing to settle, fraud, misleading reports/ valuations, system failures, trading errors, regulatory risk and staff (human) errors.
Operational risk issues at investment banks are costly to address, but the reputational repercussions also can affect stock prices.
Note on Diversification
You can see from each of the types of risk, the best strategy for reducing risk is good diversification.
This reduces the risks of any one particular investment, asset class, market (i.e. UK, Emerging Markets etc). This minimises the chance of an overall portfolio suffering a loss and increases the probability of good overall investment growth.
However, it is important to note, that some risks cannot be diversified against.
Summary
Hopefully, this content has been useful in helping you understand the different types of investment risk and the need for diversification although some risks such as market risk, cannot be diversified against.
Its also important that you do not invest in any investment that is higher than your risk tolerance or capacity for loss and to make sure you a comfortable with the level of risk taken and the impact of any potential losses.
Please keep checking back for a range of blog content and insights from us like this blog, and updates and insights from a range of leading fund managers and investment houses.
Andrew Lloyd
07/10/2020