Risk is a part of life. Everything we do has some type of risk involved. With investing it’s critical to manage the risks.
The easy way to describe risk, and management of it is like this: If you put $100 into a new business, it could turn into $1,000 or zero. You don’t know which of those two outcomes will arise. If you put $1 into each of 100 businesses, each has a chance of earning $10 or zero. You still don’t know which outcome will arise, but you’re much more likely to some success.
You manage your risk by not putting all your eggs into one basket.
While you can’t eliminate risk this way, you can reduce the overall impact of it. In a sense the risk for each of the 100 businesses will be the same. But because you limit your overall exposure ($1 vs $100 or 1% vs 100%) on a single business you limit your potential loss, and also your potential gain. This is called diversification.
This diversification spreads the risk of total failure. And while you don’t earn the same amount on a winning business, you don’t lose everything. So you can spread your total investment across different businesses, asset classes, investment opportunities and across all your investments, hopefully, continue to increase your investment.
Types of risk
The main types of risk to be aware of as in investor is Credit risk, interest rate risk, liquidity risk, reinvestment risk, inflation risk, exchange rate risk, and finally event risk.
Credit or counter party risk is the most significant to be aware of, and is the risk that the issuer or counter-party of the security will fail. So the bond issuer defaults on the debt, the stock is worthless if the company goes broke. With bonds, a higher credit risk will be compensated for with higher coupon rates.
Interest rate risk is when market yield rise, bond prices fall and when market yields fall, bond prices rise. When market yields rise, the previous issued bonds need to attract investment with higher yields. If you try to sell a bond before maturity, you will gain or lose capital as the demand for the bond will change according to the current interest rates.
Reinvestment risk is the risk when you are forced to reinvest the capital from a matured bond at times when the interest rate is low.
Inflation risk is related to fixed interest bonds. As inflation increases over time, the buying power of your capital shrinks and thus the reduced investment from the bond. There are various inflation linked bonds designed to combat this.
Exchange rate risk is applied when monies are invested in a foreign currency. If the foreign currency decreases against local currency, the value of the security will be reduced.
Event risk such as natural disaster, accident, war are some examples of external unforeseen events that affect the issuing company.
Liquidity risk is the risk that the investor will not be able to exit from the position quickly, or can only sell at a reduced price.
Please call us if you’d like to discuss the risks most impacting your portfolio.