We often make choices not knowing the exact outcome, and investing is no exception. Therefore, understanding investment risk and your risk appetite can be key to making informed investment decisions. In this article, we introduce the concept of investment risk and the strategies that investors can use to reduce exposure to risk.
Risk and investing
Investment risk is the chance that you don’t achieve the return you expected – including the possibility of losing some or all of your invested funds.
Assessing risk can be somewhat tricky. From a psychological perspective, it’s almost impossible to measure risk objectively; however, in finance, investors found a way to quantify risk by looking at the historical performance of an investment. This measure is called standard deviation. By looking back at the pricing history of a particular investment, standard deviation tries to predict how much the actual return might differ from the expected return – including the chance that the return might be higher than expected. If the price of an investment is known to change unexpectedly and often, it would be considered volatile and have a high standard deviation. When the standard deviation is high, it’s more likely that an investment’s actual return will not be as expected.
So, what are the main risks of investing?
There are two components that make up the total risk of an investment: systematic and unsystematic risk.
Systematic (market) risk
Systematic risk (also known as market risk) relates to the broader market of an investment and is caused by major events such as war, political instability, recessions, and pandemics. These events can affect entire sectors or markets and influence factors such as:
- Inflation rates
Inflation determines how expensive it is to buy or supply goods and services. Rising or falling inflation rates flow through to investments in different ways depending on the asset class. For example, commodities tend to do well when inflation is growing because they drive the underlying price of inflation; however, commodity prices (and returns) suffer when inflation falls.
- Interest rates
Interest rates determine how costly it is to borrow and save funds. With investing, changing interest rates affect many asset classes. For example, when interest rates are low, investors like bonds because of their higher fixed interest rates, which drives up bond prices. However, when interest rates are high, the fixed interest rate offered by bonds is no longer as attractive, and bond prices decline as a consequence.
- Exchange rates
A currency’s exchange rate is determined by factors such as local interest rates, inflation, politics, trade levels, and government debt. If you have investments in foreign currency, changes in the exchange rate can affect your overall returns.
A well-known measure of the systematic (or market) risk component of an investment is called beta. It’s essentially a “market sensitivity index,” which indicates how volatile an investment is compared to the broader market1. A high beta implies that an asset is very sensitive to market changes, whereas a low beta indicates less sensitivity. Investments with high betas are considered higher-risk. However, high beta investments usually offer higher potential returns, so these opportunities often remain attractive to risk-taking investors.
Systematic risk is typically hard to avoid as most investments have exposure to it. Therefore, investors must be comfortable taking on some level of risk to earn returns – a concept often referred to as the risk-reward trade-off. With investing, the potential return (reward) usually increases as risk exposure increases.
Unsystematic risk relates to the unique risks of a company or industry and is specific to the individual investment. The main types of unsystematic risk that affect investment returns are:
- Financial risk
The ongoing ability of a company to meet its financial obligations is a common source of investment risk. To be profitable and continue growing, companies need to have consistent cash flow and a solid financial foundation to deal with unexpected costs.
- Regulatory and legal risk
Changes in laws and regulations often result in companies having to adjust their operations, which can induce extra costs and either slow down or stop operations altogether.
- Strategic risk
Strategic threats such as new competitors entering the market can impact demand for a product or service. In addition, a company’s offering can become more or less desirable as customer needs and technology evolves, so companies can be required to spend a lot of time and money to make sure they stay relevant.
- Operational risk
Sometimes businesses make crucial mistakes when planning and executing their operational processes; for example, when a company runs out of an essential resource it needs to manufacture a product.
- Reputational risk
Businesses can experience financial stress if people perceive their brand negatively. A company or its employees can damage its reputation by making unfavorable decisions, or controversial parties they work with could contribute to a bad brand image.
Diversification: A strategy to reduce risk
Unlike systematic risk, investors can reduce their exposure to unsystematic risks through an investment strategy called diversification. This strategy aims to reduce the overall risk of your portfolio by spreading unsystematic risk across multiple investments such as various asset classes, geographies, currencies, and maturities.
When you have multiple investment types within a portfolio, the lower-risk investments tend to offset the higher-risk investments – essentially “smoothing out” the portfolio’s total risk. For example, bonds (a low-risk investment) reduce overall portfolio risk when added to a portfolio of only stocks (a higher-risk investment). Although this doesn’t necessarily result in the highest possible returns, you’re more likely to average out an overall profit even if you make some losses. On Mintos, for example, investors with more diversified portfolios tend to achieve more stable annual returns. Read more about the basics of diversification.
Why risk appetite is important
When it comes to making investment decisions, there’s a big difference between the risk of an investment and your personal appetite for risk.
Risk appetite often depends on an investor’s age and the nature of their investment goals. For example, if an investors’ goal is to preserve capital in the short-term, it would require a low-risk approach and, therefore, a more conservative investment strategy. Whereas for longer-term goals such as retirement, investors may be willing to accept higher levels of risk for higher returns, as there is time for any peaks or drops in the market to be “smoothed out” before they need the funds. Read more about setting investment goals.
Other tools for assessing investment risk
Worldwide, there are companies providing rating tools to assist investors in learning more about investment opportunities. S&P Global, for example, provides credit ratings based on extensive research for corporate and government bonds, helping to determine a bond’s risk level. On Mintos, there’s the Mintos Risk Score, which is given to all investments on the platform. Monitored and updated regularly, it aims to inform investors about the current risk level of a lending company.
In addition, licensed investment firms issue prospectuses and Key Information Documents, which are documents that provide all the details of an investment offering. Although investors shouldn’t solely use these tools to make investment decisions, they can be helpful in your risk assessment of investment opportunities across many asset classes.
Understanding investment risk is crucial for making investment decisions that align with your comfort level and expectations. In this article, we introduced the main concept of investment risk; however, it’s important to note that each asset class has its own unique risk characteristics that influence investment returns.
- Modigliani, F. & Pogue, G. A. (1973) An introduction to risk and return concepts and evidence, 646-73