Types of Investment Risk

by KenFaulkenberry

in Risk

Types of Investment Risk

Types of Investment Risk

An important aspect of investing is understanding the types of investment risk and the best procedures to minimize the negative effects on a portfolio.

It is a given that an investor must take risk in order to achieve rates of return above a risk-free rate of return. Because the risk-free rate of return (i.e. Treasury Bill rate) is near zero; most investors are being forced to accept additional risk to achieve investment returns that will meet their long term goals.

What is Investment Risk?

Most of us think of risk as negative. I’m going to encourage you to think a little differently about it. Risk is a deviation of an expected outcome. In investing we can look at risk as a deviation of expected investment returns.

The deviation from the expected return can be either positive or negative. The probability and magnitude of the deviation is what an investor is concerned about. There are many factors that can affect risk and there are portfolio management tools to measure and mitigate the risk factors.

Understanding the types of investment risk allows an investor to manage risk and optimize returns. Let’s look at the different types of investment risk and how a portfolio manager can use the tools available to improve their probability of positive outcomes instead of negative outcomes.


Related Reading: Perceived Risk vs. Real Risk: A Key to Successful Value Investing

Three Most Important Types of Investment Risk

Market Risk

Market risk, also known as systematic risk, is risk affiliated with market returns. These can include macroeconomic factors such as interest rates, inflation, recessions, currencies, politics, etc.

In the short term stock market prices cannot be predicted. But long term returns can be predicted with some accuracy. In other words, the variation of returns (risk) is less over long periods of time than short periods of time.

Long term market returns are inversely correlated with valuations. This is why investors should use a tactical asset allocation which invests more in assets when they are selling at bargain prices and less aggressively when valuations are high. A long term investment horizon together with  an active asset allocation strategy allows an investor to partially mitigate market risk.

Specific Risk

Specific risk, also known as unsystematic risk, is risk that is not correlated with market returns. It is the risk that is specific to a particular company or industry. An individual investment, such as a company, can have problems that are specific to that asset. Maybe a catastrophe (i.e. BP oil spill), bad management, a large product failure, etc. causes the individual assets price to fall. The good news is, specific risk can be nearly eliminated with diversification.

Volatility Risk

This may be the least understood and most underrated of the different types of investment risk. Did you know two different portfolios can have identical average returns but provide very different total returns? The more volatile the portfolio the lower the total return.

Very few investors match the advertised “average return” of a market index or fund because portfolio volatility eats away at your portfolio value. If you don’t understand this please read my post on portfolio volatility. It could be costing you a large portion of your retirement.

For example, if you have a negative 50% return and a positive 50% return you have an “average” return of 0%. But you have actually lost 25% of your portfolio! Very few investors realize how much their portfolio value is being affected by portfolio volatility.

Other Types of Investment Risk

Interest Rate Risk

When interest rates rise the price of bonds decline. Interest rates also affect economic activity and borrowing costs.

Default Risk

Sometimes a borrower is unable to pay back debts or bills.

Inflation Risk

Higher prices lower the purchasing power of your investments. If your investment returns don’t exceed inflation you are losing purchasing power.

Economic Risk

Economic recessions and depressions can have profound effects on asset valuations.

Reinvestment Risk

Let’s assume that many years ago you bought a Treasury Bond paying 8% that is maturing. Now the interest rate is less than 3%. If you reinvest it will have to be at a much lower rate.

Liquidity Risk

If you need to sell an investment you may not be able to find a buyer in a timely manner. Most publicly traded equity and bonds are fairly liquid. But many alternative investments such as real estate, art work, coins, stamps, etc. may experience periods when they are illiquid.

Regulatory / Political Risk

Governments have a large effect on social stability and the economic environment for investment.  Look for political stability and business friendly policies.

Mitigating and Minimizing Investment Risk

Once you understand the different types of investment risk you can mitigate and minimize risk with portfolio management tools. Here are some places on the AAAMP Blog to delve deeper into the solutions:

Value

Portfolio Management

Risk


Written by KenFaulkenberry

KenFaulkenberry

AAAMP Blog by Ken Faulkenberry
Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record.
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{ 2 comments }

Porfirio Massey

Opportunity risk. This occurs when you lock up your money in an illiquid investment, like a fixed term deposit with very modest returns, and miss an opportunity to invest in something with a chance of much higher returns. When I first began learning to invest, I was in a hurry to get started and put around $5000 into a fixed term deposit. I didn’t know much about investing, so I plopped my savings into a guaranteed investment. About 1 day later, there was a drastic drop in the stock markets, which would have been a golden opportunity for me to buy stocks while prices were low. But I couldn’t buy stocks, because I had committed that $5000 to a 1 year fixed term deposit with no option of early redemption. I could have made some real gains on the stock market, but I was stuck with a modest 5 percent interest rate. I had avoided risk to my principal, but I was bitten by opportunity risk. You can avoid opportunity risk by keep your money in liquid investments like stocks and mutual funds with no minimum time commitments.

KenFaulkenberry

Good example.

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