What Is Risk? - The Balance

Risk is the potential to lose some or all of your money when you invest. There are multiple types of risks you should understand before making an investment ... LinkedInwithBackground Investing PortfolioManagement WhatIsRisk? RiskExplainedinLessThan5Minutes ••• PetriOeschger/GettyImages TableofContents Expand TableofContents DefinitionandExamplesofRisk TypesofRisk DoINeedRisk? WhatRiskMeansforIndividualInvestors By TJPorter FullBio LinkedIn Twitter TJPorterhasoversevenyearsofexperiencewritingaboutinvesting,stocks,ETFs,banking,credit,andmore.Hehasbeenpublishedonwell-knownpersonalfinancesiteslikeBankrate,CreditKarma,MoneyCrashers,DollarSprout,andmore.TJhasabachelor'sinbusinessadministrationfromNortheasternUniversity. Learnaboutour editorialpolicies UpdatedNovember30,2021 Reviewedby AkhileshGanti Reviewedby AkhileshGanti FullBio AkhileshGantiisaforextradingexpertandregisteredcommoditytradingadvisorwhohasmorethan20yearsofexperience.Heisdirectlyresponsibleforalltrading,risk,andmoneymanagementdecisionsmadeatArctosFXLLC.HehasMasterofBusinessAdministrationinfinancefromMississippiStateUniversity. Learnaboutour FinancialReviewBoard Intheworldofinvesting,risktypicallyreferstothepossibilitythataparticularinvestmentwilllosesomeorallofitsvalue.Ingeneral,investmentsmustcompensatefortheirriskbyofferingsignificantpotentialreturns. Thisarticlewilldiscussthedifferenttypesofriskandhowyoucanassessthoseriskswheninvesting. DefinitionandExamplesofRisk Wheninvesting,riskreferstothepossibilitythataninvestmentwilllosevalueinsteadofgainvalueovertime.Eachinvestmenthasdifferentlevelsofrisk.BondsorCDstendtobelessriskythanstocks,butallinvestmentsinvolvesomelevelofrisk. Forexample,ifyoubuyashareinacompany,thevalueofthatsharecanchange,eitherrisingorfalling.Thereisariskthatthepriceofthesharewillfallafteryoupurchaseit.Intheworstcase,thecompanywillgobankrupt,leavingyouwithworthlessstockinabusinessthatnolongerexists. Anexampleofadifferenttypeofriskcanoccurwhenyoupurchaseabond.Buyingabondislikegivingaloantotheorganizationsellingthebond.Thebondselleragreestopayinteresttothebondholderforasetperiod.Ifthebondsellerdoesn’thavethefundstomakeinterestpayments,you’lllosethereturnonthemoneyyouloaned. Bondholdersaretypicallypaidfirstifacompanygoesbankrupt. TypesofRisk Investorsneedtobeawareofmanytypesofrisks.Eachhasuniquecharacteristicsthataffecthowtheriskcouldimpactyourinvestments. BusinessRisk Businessriskappliestostocksandbondsissuedbycompanies.Businessesalwaysriskrunningintoproblemsthatreducetheirincomeorforcethemtoclosetheirdoors.Forexample,anincreaseinthecostofrawmaterialsmaymeanacompany’sstockdropsbecausethecompanyearnslessprofitandhasahardertimepayingbackitsdebt. VolatilityRisk Someinvestments,suchasstocks,canexperiencealotofpricevolatility.Evenalarge,stablecompanycanseeitssharepricemoveupanddown. Ifyoucanholdaninvestmentforthelongtermuntilitspricerises,volatilityriskisn’tasimportant.However,ifyourunintoasituationwhereyouneedtosellquicklyandaninvestment’svolatilityhasdroppeditspricebelowthepriceyoupaid,youmighthavetosellataloss. InflationRisk Inflationistheprocessbywhichmoneytendstolosevalueovertime.Economistsusuallyagreethatsmallamountsofinflationaregoodforaneconomy,butsometimesinflationcanrisetohigherlevels.  TheConsumerPriceIndex(CPI)isapopularmeasureofinflationintheUnitedStates.TheFederalReservecurrentlytargetsanaverageinflationrateof2%overthelongterm. Investorswhobuyfixed-incomesecuritiessuchasbondsorCDsmayseehighinflationeatawayattheirreturn.Forexample,ifabondoffers3%interestbutinflationis2%,therealreturnofthebondwillbe1%.Ifinflationrisesto4%,therealreturnofthebondwouldbe-1%. LiquidityRisk Liquidityriskdescribestheprobabilitythatyou’llhavetroublefindingsomeonetobuyyourinvestmentsifyouneedtosellthemsoyoucanusethecashforotherpurposes.There’sneveraguaranteethatsomeonewillbewillingtobuyaninvestmentyouwanttosell,andsomesecurities,suchasCDs,maychargeanearlywithdrawalpenaltyifyouliquidatebeforematurity. OtherFormsofRisk Therearemanyothertypesofriskthatinvestorsneedtobeawareof.Forexample,investinginaforeigncountrybringsfluctuatingcurrencyvaluesintoplay.Sociopoliticalriskscanbeafactorifyouinvestinabusinessthatbecomesatargetofactivistsoroperatesinanunstablecountrythatexperienceswar,famine,apandemic,oranothermajorevent. It’simportanttoperformduediligencetoidentifypotentialrisksandplanforthemwhencomingupwithaninvestmentstrategy. DoINeedRisk? Everythinginlifeinvolvessomelevelofrisk,andthatholdstrueintheinvestingworld.Evenoneofthesafestplacestoputyourmoney,anFDIC-insuredsavingsaccount,involvesinflationriskandothertypesofrisk. Theamountofriskthatyouaccept,however,isuptoyou.Ingeneral,riskandrewardarecorrelated.Themoreriskyouacceptwhenyoubuyaninvestment,thehigherthepotentialreward. Forexample,bondsaregenerallyviewedasasaferinvestmentthanstocks.Tocompensateforthehigherrisk,stocksofferhigherreturns.Overthepast10years,Vanguard’sTotalStockMarketIndexFundhasofferedareturnof14.20%comparedtoVanguard’sTotalBondMarketFund’sreturnof3.24%. Sometypesofoptionsandotherderivativescouldinvolveinfiniterisk.However,derivativesalsohavethepotentialtooffermassiveprofits. Eachinvestorneedstodeterminethelevelofriskthattheyarecomfortablewithandmatchittotheirinvestinggoals. WhatRiskMeansforIndividualInvestors Individualinvestorshavetoacceptthatinvestmentriskexists,evenininvestmentsthatseem100%safe.Therefore,it’simportanttoimplementthefollowingtwostepsasyouplanyourinvestmentstrategy. First,consideryourinvestmentgoalsandthelevelofrisknecessarytoachievethem.Makesurethatyoufullyunderstandtheamountofriskthatyou’reacceptingwhenmakinganinvestmentdecision. Second,reduceyourriskwherepossible.Onepopularwaytoreduceriskistobuildadiversifiedinvestmentportfolio.Holdingmanydifferentsecuritiescanlimittheimpactofsomeformsofriskonyouroverallperformance,increasingyourchancesofprofitingfromyourinvestments. KeyTakeaways Allinvestinginvolvesrisk.Investorsmustconsidermanydifferenttypesofrisk.Generally,riskandreturnarecorrelated.Higherriskmeanshigherpotentialreturns.Diversificationcanhelpreduceyourinvestmentrisk. ArticleSources BoardofGovernorsoftheFederalReserveSystem."WhyDoestheFederalReserveAimforInflationof2%OvertheLongerRun?"AccessedJune21,2021. Vanguard."VanguardTotalBondMarketIndexFundAdmiralShares(VBTLX)."AccessedJune21,2021. Vanguard."VanguardTotalStockMarketIndexFundAdmiralShares(VTSAX)."AccessedJune21,2021. Share Tweet Share Email 9BestBondETFsfor2022 HowToHedgeAgainstInflation WhatIsaPerpetualBond? DoesTakingonInvestmentRiskDeliverHigherReturns? NewtoInvesting?DabbleWitha'Fun'Stock WhatAreIntermediate-TermBondFunds? WhatIsaSafeHaven? WhatIsaRisk-FreeAsset? WhatIsMarketRisk? ShouldYouInvestinMutualFundsorStocks? WhatIsUnsystematicRisk? FiveTypesofBonds,theDurations,andRiskLevels WhatIsFinancialRiskManagement? ShouldYouInvestinTreasuryInflation-ProtectedSecurities(TIPS)? HowtoSpotaHigh-RiskInvestmentThatMayLoseYouMoney LearnHowtoBeatInflationWithMutualFundsandETFs