Whenever you make any investment, you’re exposed to different types of risk that could affect the actual gains of your investment. The only way is understanding the type of risks involved in a particular investment and take necessary precautions to minimize the risk. As Warren Buffett once said, “Risk comes from not knowing what you are doing.” Remember, whatever investment you made, the risks and investment go hand-in-hand. Whether you invest in stocks, mutual funds, ETFs, bonds, or any other money-market security, there is no such thing as a risk-free investment.
It is not just about investment, even performing our day-to-day activities, we are exposed to some sort of risk. Whether you are driving, walking down the road, cutting vegetables or something else. It is important to find out the type of risks you are exposed to and take necessary measures.
Types of Risks Involved in an Investment
Here, we’ve enlisted some of the common risk types involved in different investments to help you learn how these risks affect your investments and ultimately, your investment goals and returns:
It refers to the possibility of experiencing losses due to performance of the overall financial markets in which an investor is involved. Market risk is also known by systematic risk and one cannot eliminate it through diversification however an investor can hedge against in other ways. It can happen for numerous reasons such as recession, economic slowdown, movement in interest rates, natural disaster, political turmoil, terrorist attack, pandemic or something else.
It refers to the marketability of any investment that can be quickly bought or sold without bearing losses. As you are familiar that mutual fund units can be instantly bought or sold irrelevant to the market conditions. If you are holding some mutual fund units and are in profit, you can instantly sell them to make potential gains. But, that’s not the case with a real-estate investor who is holding onto land. At the time of urgency, it would be difficult for him to sell the land at a profitable price.
It shows that mutual funds have higher liquidity than real-estate investments. Similar to this, different asset classes carry different liquidity risks which affect the investment and ultimately, return on investment.
There is a saying, “Do not put all your eggs in one basket.” Concentration risk refers to the risk involved in an investment made in a single asset class. If you are more concentrated on one investment, your all financial goals, and entire return will depend on the performance of that asset-class which by the way is too risky. Thus, diversify your investments to spread the risk over different types of asset classes, industries to ensure you are not too concentrated on one.
The credit risk refers to the risk that a government entity that issued the bond will not able to pay the interest or repay the principal amount at maturity. It generally applies to debt investments such as bonds. Although it is impossible to know for sure who will default on obligations however one can assess the credit risk based on the credit ratings of the bond investment. For instance, AAA credit rating indicates the lowest possible credit risk.
It refers to the risk that inflation will undermine the returns on investment through declining in purchasing power as inflation erodes the purchasing power of money over time. It generally happens in the debt investments as the returns are moderate and cannot always compete against inflation rate. However, stock investing offer some sort of protection against inflationary risk but it also carries high-risk too. Similar to equities, many other financial instruments have the quality to counter inflationary risks.
Above, we’ve listed some common types of risk involved that arise at the time of investing. It would be not surprising if you are exposed to multiple risks in a single investment. That’s why it is important to have a clear understanding of such risks to safeguard your returns while minimizing the risks.