Investments in securities are subject to various risks. However, that can be minimized with multiple strategies. This SIE study guide page covers the investment risks and some effective risk-mitigating techniques.
Types of Investment Risk
Investment risk refers to the potential for financial loss inherent in various investments. Understanding these risks is crucial for making informed investment decisions and managing your portfolio effectively.
Every investment carries some risk, and investors may lose some or all of the initial investment if things don’t go in their favor. Here is the list of several investment risks:
- Market Risk: Also known as systematic risk, is the potential for an investor to experience losses due to factors that affect the overall performance of the financial markets. Market risk is influenced by broad economic factors such as recessions, political instability, and natural disasters. You must have seen that The Great Recession of 2008 and the COVID-19 pandemic hugely affected global stock markets.
- Business Risk: It is associated with a specific company or industry. It refers to the potential for a business to fail or perform poorly due to internal issues such as poor management, operational inefficiencies, or product obsolescence. Investors in a single company or sector are particularly exposed to business risk.
- Inflationary Risk: Also known as purchasing power risk, it is the danger that the value of returns on an investment will be eroded by inflation. If the inflation rate exceeds the rate of return on an investment, the actual value of the investment’s returns will decline.
- Interest Rate Risk: Interest rate risk is the potential for investment losses due to changes in interest rates. This risk is particularly relevant for fixed-income securities such as bonds. When interest rates rise, the prices of existing bonds typically fall, and vice versa.
- Credit Risk: Also known as default risk, it is the possibility that a borrower will fail to make the required payments on their debt obligations. This risk affects bondholders and lenders. Higher credit risk typically corresponds to higher yields to compensate investors for the increased risk.
- Foreign Currency Risk: Foreign currency risk, or exchange rate risk, arises from fluctuations in the value of one currency relative to another. Investors holding international investments are exposed to this risk. Currency exchange rate changes can affect the value of foreign investments and profits earned from them.
- Liquidity Risk: Liquidity risk is the risk that an investor may not be able to buy or sell an investment quickly without significantly affecting its price. Investments in thinly traded stocks or real estate can be particularly susceptible to liquidity risk.
- Prepayment Risk: This is primarily associated with fixed-income securities, especially mortgage-backed securities. This risk occurs when borrowers pay off their loans earlier than expected, resulting in the reinvestment of the proceeds at lower interest rates.
- Political Risk: Political risk, or geopolitical risk, is the risk that an investment’s returns could suffer due to political changes or political instability in a country. This includes changes in government, legislative bodies, other foreign policymakers, or military control.
Risk Mitigation Strategies
Securities investments are subject to various risks. However, the risk can be minimized by following some simple strategies. Here are a few risk mitigation strategies that finance experts follows:
- Diversification: This involves spreading investments across various asset classes, sectors, and geographical regions to reduce exposure to any single investment’s risk. By holding a diversified portfolio, the negative performance of some investments can be offset by positive performance in others.
- Alternative (Non-Securities) Investments: Investing in alternative assets, such as real estate, commodities, or private equity, can provide additional diversification and reduce overall portfolio risk. These investments often have low correlations with traditional securities, offering potential risk reduction benefits.
- Hedging: It involves using financial instruments, such as options, futures, and other derivatives, to offset potential losses in an investment. For example, an investor might use options contracts to protect against declines in stock prices.
- Portfolio Rebalancing: It is the process of realigning the weightings of a portfolio of assets to maintain a desired risk level. This typically involves periodically buying and selling assets to keep the original or desired asset allocation level.
- Sector Rotation: This investment strategy involves shifting investments from one sector to another in response to economic cycles or other factors. This strategy can help investors capitalize on the relative strengths of different sectors at various times and manage risk.