Risk and reward go hand in hand when you are investing. You need to be able to define investment risk for every investment that you engage in. In any investment, the risk is the chance that your investment gains will be different from the outcome you expect. That risk always includes the chance that you will lose some or all of your investment capital. In trying to determine risk before going into an investment, the most common way is to look at how the same type of investment usually turns out. Using tools such as the standard deviation, investors get a sense of just how risky or safe an investment likely is.
Different Types of Investment Risk
Some types of investment risk have to do with the type of investments you make. Some have to do with things like your age, how long you plan to stay invested, and how long you may need to accumulate capital for things like starting your own business or having money for retirement that does not run out. Here are the usual investment risks:
This group of risks includes changes in interest rates, relative currency valuations, and the prices of stocks that you purchase.
This is the risk of not being able to get out of an investment when it goes bad. One of the strongest reasons for investing in US stocks on the NYSE or NASDAQ is that they generally trade with a good degree of liquidity. Nevertheless when an overpriced market corrects, you will generally have to take a loss when getting out unless you have protected yourself with put options.
This risk is why most investors diversify their investments. When all of your capital is tied up in one stock, one real estate project, or one type of bond, you will lose across the board with the investment goes bad. Diversification can be investing in several stock sectors, real estate, and in different countries.
This is the risk that a company or a country that issues bonds will not be able to pay. Investors assess credit risk by looking at credit rating. The best credit rating is AAA and in the USA only two companies have AAA ratings, Johnson & Johnson and Microsoft.
This risk has to do with interest rates. You purchased bonds at 5% interest and they have matured. But when you want to buy today the interest rates are nearly zero. This is the reinvestment risk associated with low interest rates in the current era. The same applies to reinvesting interest paid except when you simply spend the money!
Inflation risk is the loss of purchasing power of your money when the currency devalues. In the 1970s interest rates were high but inflation was higher. Thus investors lost purchasing power with bank accounts, bonds, and treasuries. Those who invested in stocks saw share prices go up and real estate kept up because prices rose. Gold was very popular and rose from $32 an ounce to nearly $800 before it corrected back to the $200 to $300 range.
Investment Horizon Risk
This risk has to do with how long you need to stay invested in order to see a profit. Stocks tend to outperform other investments over the long term but if you lose your job and need to sell stocks during a market correction you will lose money.
Other risks include devaluation of foreign currencies when you invest offshore and simply running out of money as you live long and use up your savings.
Investment Risk Reward
All investments have a potential risk to reward ratio. For example, an investment risk reward ratio of 1:5 means that you are willing to risk $1 for the possibility of making $5. In general, investors look for at least a 1 to 3 risk reward ratio when they are putting their capital at risk. However, folks who want to invest without losing any money will be happy with a bond that returns a set rate of interest and returns their capital when it has matured. Unfortunately, anyone with such investments needs to accept the risk of inflation eating up their purchasing power and the possibility that rates will get ever worse to go negative!
Investment Risk and Return Analysis
The first thing that most investors consider when investing is the history of a given type of investment. Well-chosen stocks tend to go up over time. The same applies to real estate and both also have their bubbles and crashes. The longer you plan to stay invested and the greater margin of safety you have, you can simply wait out the down times and expect to make money in the long term. If you are trying to time the market, you may become rich and you may lose everything. The key to avoiding such disasters is to start by assessing the intrinsic value of any investment and then paying close attention to the details along the way.
How to Calculate the Risk of an Investment
The first step in calculating investment risk is to look at how your type of investment has done over time. What is the maximum return you might expect and what is the worst case scenario? What the most common scenario and how often does that occur. Then to calculate the risk of an investment you need to look closely at the details associated with best case, worst case, and average scenarios. What conditions favor the best case and what situations will lead to an investment disaster? In short, you need to know exactly how a given investment works in order to make a profit!
Reducing Your Investment Risk
There are four good ways to reduce your risk when investing. The first is to avoid putting all of your eggs in one basket. Diversify and spread out your risk. The second is to be clear about your goals when you invest. Don’t find yourself holding a 10-year Treasury when you need the money in 5 years! Then, pay attention. We have writing about the pros and cons of dollar cost averaging. One risk of this approach is that you get lulled into a false sense of security and quit paying attention! A good approach for the average investor is to keep your portfolio small enough that you can easily keep track of each investment.
How to Minimize Risk in Investment
If you simply don’t want to deal with the risk of losing money in your investments you typically need to accept a lower projected rate of return. Folks going into retirement often move a larger part of their portfolio from stocks to bonds and treasuries as they are assured of an income without their principal being at risk. But this approach needs to be adjusted a bit at times like now when interest rates are likely to remain low for a long time. A better approach, in this case, may be secure dividend stocks that are both sources of steady income and likely to appreciate in value over the years.
Components of Investment Risk
When you read about the components of investment risk, you see lists of external risks like changes in interest rates, liquidity, and the economy. But, the biggest component of investment risk lies with the individual investor. Successful investing takes time, patience, experience, and sound judgment. A person who makes a good income in their profession will have money to invest. They have the same or great intelligence as successful investors. What they lack are the time to track their investments, patience needed to wait for good results, and experience. Taking time away from their work means lost income and investing without having the time and experience results in lost investments. Warren Buffett has suggested that most investors in this situation are best served by an ETF that tracks the S&P 500 than by trying to pick and choose individual investments!
Define Investment Risk – Slideshare Version