Definition and Examples of Risk
When investing, risk refers to the possibility that an investment will lose value instead of gain value over time. Each investment has different levels of risk. Bonds or CDs tend to be less risky than stocks, but all investments involve some level of risk.
For example, if you buy a share in a company, the value of that share can change, either rising or falling. There is a risk that the price of the share will fall after you purchase it. In the worst case, the company will go bankrupt, leaving you with worthless stock in a business that no longer exists.
An example of a different type of risk can occur when you purchase a bond. Buying a bond is like giving a loan to the organization selling the bond. The bond seller agrees to pay interest to the bondholder for a set period. If the bond seller doesn’t have the funds to make interest payments, you’ll lose the return on the money you loaned.
Bondholders are typically paid first if a company goes bankrupt.
Types of Risk
Investors need to be aware of many types of risks. Each has unique characteristics that affect how the risk could impact your investments.
Business risk applies to stocks and bonds issued by companies. Businesses always risk running into problems that reduce their income or force them to close their doors. For example, an increase in the cost of raw materials may mean a company’s stock drops because the company earns less profit and has a harder time paying back its debt.
Some investments, such as stocks, can experience a lot of price volatility. Even a large, stable company can see its share price move up and down.
If you can hold an investment for the long term until its price rises, volatility risk isn’t as important. However, if you run into a situation where you need to sell quickly and an investment’s volatility has dropped its price below the price you paid, you might have to sell at a loss.
Inflation is the process by which money tends to lose value over time. Economists usually agree that small amounts of inflation are good for an economy, but sometimes inflation can rise to higher levels.
The Consumer Price Index (CPI) is a popular measure of inflation in the United States. The Federal Reserve currently targets an average inflation rate of 2% over the long term.
Investors who buy fixed-income securities such as bonds or CDs may see high inflation eat away at their return. For example, if a bond offers 3% interest but inflation is 2%, the real return of the bond will be 1%. If inflation rises to 4%, the real return of the bond would be -1%.
Liquidity risk describes the probability that you’ll have trouble finding someone to buy your investments if you need to sell them so you can use the cash for other purposes. There’s never a guarantee that someone will be willing to buy an investment you want to sell, and some securities, such as CDs, may charge an early withdrawal penalty if you liquidate before maturity.
Other Forms of Risk
There are many other types of risk that investors need to be aware of. For example, investing in a foreign country brings fluctuating currency values into play. Sociopolitical risks can be a factor if you invest in a business that becomes a target of activists or operates in an unstable country that experiences war, famine, a pandemic, or another major event.
It’s important to perform due diligence to identify potential risks and plan for them when coming up with an investment strategy.
Do I Need Risk?
Everything in life involves some level of risk, and that holds true in the investing world. Even one of the safest places to put your money, an FDIC-insured savings account, involves inflation risk and other types of risk.
The amount of risk that you accept, however, is up to you. In general, risk and reward are correlated. The more risk you accept when you buy an investment, the higher the potential reward.
For example, bonds are generally viewed as a safer investment than stocks. To compensate for the higher risk, stocks offer higher returns. Over the past 10 years, Vanguard’s Total Stock Market Index Fund has offered a return of 14.20% compared to Vanguard’s Total Bond Market Fund’s return of 3.24%.
Some types of options and other derivatives could involve infinite risk. However, derivatives also have the potential to offer massive profits.
Each investor needs to determine the level of risk that they are comfortable with and match it to their investing goals.
What Risk Means for Individual Investors
Individual investors have to accept that investment risk exists, even in investments that seem 100% safe. Therefore, it’s important to implement the following two steps as you plan your investment strategy.
First, consider your investment goals and the level of risk necessary to achieve them. Make sure that you fully understand the amount of risk that you’re accepting when making an investment decision.
Second, reduce your risk where possible. One popular way to reduce risk is to build a diversified investment portfolio. Holding many different securities can limit the impact of some forms of risk on your overall performance, increasing your chances of profiting from your investments.
- All investing involves risk.
- Investors must consider many different types of risk.
- Generally, risk and return are correlated. Higher risk means higher potential returns.
- Diversification can help reduce your investment risk.