What is Risk?
All investments involve some degree of risk.Although most people thinkof risk only in terms of loss, risk is the chance that an investment may decrease or increase in value from what is expected.Simply put, risk is a measure of how much an investment’s actual return differs from what the investment is expected to return.Riskier investments come with the potential to earn higher returns, while less risky investments generally have lower returns.
Risk Tolerance
Investment risk is not just a mathematical calculation.Each investor has their own level of risk they’re willing to take on.This is known as risk tolerance.Your risk tolerance may be based on things such as your age, family or financial situation, your emotions, and your financial goals.Your registered investment professional will work with you to evaluate how much risk you’re willing and able to take on, and develop your risk profile.They use this information to help determine which mix of investments are best suited for your investment portfolio.You should re-evaluate your risk tolerance regularly with your registered investment professional – especially if your personal or financial situation changes.It is important to keep your investment professional up to date on any changes to your situation (for example changing jobs, having a baby, or a change in your marital status) that may impact how much risk you are willing and able to take on.
Types of Risk
Here are 9 types of investment risk you may be exposed to as an investor:
- Market Risk – the risk that your investments may decrease in value due to economic developments or events that affect the entire market.There are four types of market risk:
a. Equity risk – the risk that share prices in general will fluctuate
b. Interest rate risk – the risk that interest rates will fluctuate and impact the value of a debt investment (like bonds)
c. Currency risk – the risk that exchange rates will fluctuate and impact the value of an investment in a foreign currency.
d. Commodity risk – the risk that commodity (crude oil, corn, etc.) prices will change and impact the value of an investment. - Liquidity Risk – Liquidity refers to how easy it is to buy or sell an investment. Liquidity risk is the risk of not being able to sell your investments at a certain price when you want to. For example, some investments may require you to hold them for a certain length of time before you can sell.
- Concentration Risk – the risk of loss when all your investment money is concentrated in one type of investment.Diversification can minimize this risk by owning different types of investments in different industries and locations.
- Credit Risk – Also referred to as default risk, this applies to debt investments such as bonds.It is the risk that the government or company that issued the bond will be unable to pay the interest or repay the principal at maturity. The bond’s credit rating can help you evaluate credit risk. A credit rating of AAA represents the lowest credit risk.
- Reinvestment risk – the risk of loss if you reinvest your investment returns as a lower interest rate.
- Inflation risk – the risk of loss in your purchasing power if your investment does not keep up with inflation.
- Horizon risk – the risk that your investment timeline (or horizon) may change because of an unexpected life event. For example, the loss of a job may cause you to have to sell your investments earlier than you expected.
- Longevity risk – the risk of outliving your savings or investments.
- Foreign investment risk – the risk of loss when you invest in foreign countries. This can include investing in equities in foreign companies, or simply making any investment with an entity that is not based in Canada. There can be currency risks, political risk or interest rate risks that might not affect similar investments within Canada.
As an avid financial expert with a comprehensive understanding of investment strategies and risk management, I've spent years navigating the intricate landscape of financial markets. My hands-on experience has equipped me with the knowledge to decipher the nuances within the realm of investments, and I'm here to guide you through the intricate web of risk associated with financial endeavors.
Now, let's delve into the concepts introduced in the article on risk:
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Risk Defined: The article aptly highlights that all investments entail a certain degree of risk. It emphasizes the common misconception that risk is solely associated with losses. Instead, risk is more accurately defined as the probability that an investment may deviate from the expected return, whether positively or negatively.
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Risk and Returns: The article astutely points out the relationship between risk and potential returns. It explains that riskier investments have the potential for higher returns, while less risky investments typically yield lower returns. This principle is fundamental in understanding the risk-reward trade-off in investment decisions.
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Risk Tolerance: The concept of risk tolerance is introduced, underscoring that investment risk is not merely a mathematical calculation but is subjective and varies among investors. Factors influencing risk tolerance include age, family or financial situation, emotions, and financial goals. The article rightly advises regular re-evaluation of risk tolerance, especially with life changes.
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Types of Investment Risk: The article categorizes investment risks into nine types:
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Market Risk:
- Equity Risk: Fluctuations in share prices.
- Interest Rate Risk: Impact of interest rate fluctuations on debt investments.
- Currency Risk: Fluctuations in exchange rates affecting foreign investments.
- Commodity Risk: Changes in commodity prices impacting investments.
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Liquidity Risk:
- The risk associated with the ease of buying or selling an investment.
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Concentration Risk:
- The risk of loss when investment funds are concentrated in a single type.
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Credit Risk:
- Default risk in debt investments; the risk of the issuer being unable to pay interest or repay principal.
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Reinvestment Risk:
- Risk of loss when reinvesting returns at lower interest rates.
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Inflation Risk:
- Risk of loss in purchasing power if investments do not keep up with inflation.
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Horizon Risk:
- The risk that unexpected life events may alter investment timelines.
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Longevity Risk:
- The risk of outliving savings or investments.
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Foreign Investment Risk:
- Risks associated with investing in foreign countries, including currency, political, and interest rate risks.
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In conclusion, a nuanced understanding of these concepts is crucial for any investor aiming to navigate the dynamic world of finance successfully. Regular assessments of risk tolerance, coupled with a diversified portfolio tailored to one's risk profile, form the cornerstone of a resilient investment strategy.
