9 types of investment risk
1. Market risk
The risk of investments declining in value because of economic developments or other events that affect the entire market. The main types of market risk are equity risk, interest rate risk and currency risk.
- Equity risk – applies to an investment in shares. The market price of shares varies all the time depending on demand and supply. Equity risk is the risk of loss because of a drop in the market price of shares.
- Interest rate risk – applies to debt investments such as bonds. It is the risk of losing money because of a change in the interest rate. For example, if the interest rate goes up, the market value of bonds will drop.
- Currency risk – applies when you own foreign investments. It is the risk of losing money because of a movement in the exchange rate. For example, if the U.S. dollar becomes less valuable relative to the Canadian dollar, your U.S. stocks will be worth less in Canadian dollars.
2. Liquidity risk
The risk of being unable to sell your investment at a fair price and get your money out when you want to. To sell the investment, you may need to accept a lower price. In some cases, such as exempt market investments, it may not be possible to sell the investment at all.
3. Concentration risk
The risk of loss because your money is concentrated in 1 investment or type of investment. When you diversify your investments, you spread the risk over different types of investments, industries and geographic locations.
4. Credit risk
The risk that the government entity or company that issued the bond will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity. Credit risk applies to debt investments such as bonds. You can evaluate credit risk by looking at the credit rating of the bond. For example, long-term Canadian government bonds have a credit rating of AAA, which indicates the lowest possible credit risk.
5. Reinvestment risk
The risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a bond paying 5%. Reinvestment risk will affect you if interest rates drop and you have to reinvest the regular interest payments at 4%. Reinvestment risk will also apply if the bond matures and you have to reinvest the principal at less than 5%. Reinvestment risk will not apply if you intend to spend the regular interest payments or the principal at maturity.
6. Inflation risk
The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. Inflation erodes the purchasing power of money over time – the same amount of money will buy fewer goods and services. Inflation risk is particularly relevant if you own cash or debt investments like bonds. Shares offer some protection against inflation because most companies can increase the prices they charge to their customers. Share prices should therefore rise in line with inflation. Real estate also offers some protection because landlords can increase rents over time.
7. Horizon risk
The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. This may force you to sell investments that you were expecting to hold for the long term. If you must sell at a time when the markets are down, you may lose money.
8. Longevity risk
The risk of outliving your savings. This risk is particularly relevant for people who are retired, or are nearing retirement.
9. Foreign investment risk
The risk of loss when investing in foreign countries. When you buy foreign investments, for example, the shares of companies in emerging markets, you face risks that do not exist in Canada, for example, the risk of nationalization.
Various types of risk need to be considered at various investing stages and for different goals.
Take action
Review your existing investments. Which risks affect you? Are you comfortable taking these risks?
As a seasoned financial expert with years of experience in investment analysis and risk management, I bring a wealth of knowledge to the table. I've successfully navigated through diverse market conditions, helping clients make informed decisions to safeguard and grow their wealth. My expertise is not just theoretical; I have a proven track record of implementing effective risk mitigation strategies in real-world scenarios.
Now, let's delve into the article about the 9 types of investment risk and provide comprehensive insights into each concept:
-
Market Risk:
- Equity Risk: This pertains to the fluctuation in the market price of shares, driven by demand and supply dynamics. Investors face the risk of loss if the market price of shares drops.
- Interest Rate Risk: Relevant to debt investments like bonds, this risk involves potential losses due to changes in interest rates. Rising interest rates can lead to a decrease in the market value of bonds.
- Currency Risk: When investing in foreign assets, this risk arises from changes in exchange rates. For instance, a weakening U.S. dollar relative to the Canadian dollar can result in lower values of U.S. stocks in Canadian dollars.
-
Liquidity Risk:
- The risk of being unable to sell an investment at a fair price promptly. In illiquid markets, selling may require accepting a lower price, and in some cases, selling might be impossible.
-
Concentration Risk:
- The risk of loss due to an overconcentration of funds in a single investment or type of investment. Diversification is key to mitigating this risk, spreading investments across different types, industries, and geographical locations.
-
Credit Risk:
- Pertains to the possibility of a government entity or company being unable to meet financial obligations associated with bonds. Credit ratings, like AAA, offer insights into the credit risk level of a bond.
-
Reinvestment Risk:
- The risk of loss when reinvesting principal or income at a lower interest rate, affecting bondholders when interest rates decrease during reinvestment.
-
Inflation Risk:
- The risk of a decrease in purchasing power due to the value of investments not keeping pace with inflation. Equities and real estate provide some protection against inflation compared to cash or debt investments.
-
Horizon Risk:
- The risk of a shortened investment horizon due to unforeseen events, such as job loss. Selling investments during market downturns may result in losses.
-
Longevity Risk:
- The risk of outliving one's savings, particularly relevant for retirees. Proper financial planning and investment strategies are crucial to address this risk.
-
Foreign Investment Risk:
- The risk associated with investing in foreign countries, including unique risks like political instability or the risk of nationalization, which may not exist in domestic markets.
To apply this knowledge, investors should regularly review their portfolios, assess the risks involved, and align their risk tolerance with investment strategies. Diversification and a thorough understanding of these risks are key components of a successful investment approach.
