Investment Risk: What It Is and Why It Matters
Investment risk refers to the possibility that an investment may not perform as expected, including the possibility of losing some or all of the money invested. Understanding risk is an important part of evaluating investments and financial decisions.
What Is Investment Risk?
Investment risk is the uncertainty surrounding future investment outcomes. The value of an investment can rise or fall, income from an investment can change, and expected returns may not occur.
Investment risk means that the actual outcome of an investment may be different from what an investor expects, including the possibility of financial loss.
Why Do Investments Carry Risk?
Investment values can be affected by many factors. Economic conditions, interest rates, inflation, company performance, market sentiment and unexpected events can all influence investment outcomes.
Different investments can involve different types and levels of risk. No investment decision is completely free from uncertainty.
Common Types of Investment Risk
Market Risk
Market risk refers to the possibility that investment values may change because of broader movements in financial markets.
Inflation Risk
Inflation can reduce the purchasing power of money over time. Even if the value of an investment increases, the increase may not fully offset changes in the cost of goods and services.
Interest Rate Risk
Changes in interest rates can affect the value and performance of certain investments, particularly some fixed-income securities.
Credit Risk
Credit risk relates to the possibility that a borrower or issuer may fail to make expected payments or meet financial obligations.
Liquidity Risk
Liquidity risk refers to the possibility that an investment may be difficult to sell quickly without accepting a lower price.
Concentration Risk
Concentration risk can arise when a large portion of money is invested in a single investment, sector, region or asset type.
Risk and Potential Return
Investments with different levels of risk can have different potential outcomes. However, taking more risk does not guarantee higher returns, and lower-risk investments do not guarantee protection from every type of loss.
A Simple Example
An investor purchases an investment for a specific amount. Later, market conditions change and the value falls. If the investor sells at that lower value, the investor may receive less money than was originally invested. This example is for educational purposes only.
Can Investment Risk Be Managed?
Risk cannot always be eliminated, but investors may consider ways to understand and manage it. Approaches may include diversification, asset allocation, maintaining appropriate liquidity and considering investment time horizon.
However, diversification and asset allocation do not guarantee profits or prevent all investment losses.
Risk Tolerance and Risk Capacity
Risk tolerance generally relates to a person's comfort with investment uncertainty. Risk capacity relates more closely to the financial ability to absorb potential losses or changes in investment value.
Both concepts can be relevant when considering an investment approach.
Factors to Consider When Evaluating Risk
- Your financial goals.
- Your investment time horizon.
- Your need for liquidity.
- Your existing financial obligations.
- Your ability to absorb potential losses.
- Your comfort with investment fluctuations.
- The specific risks associated with an investment.
- Investment costs and other financial considerations.
Common Mistakes to Avoid
- Assuming an investment cannot lose value.
- Ignoring inflation and purchasing power risk.
- Concentrating too much money in a single investment.
- Making decisions based only on recent performance.
- Confusing higher risk with guaranteed higher returns.
- Ignoring liquidity needs.
Key Takeaways
- Investment risk refers to uncertainty and the possibility of financial loss.
- Different investments can involve different types of risk.
- Higher risk does not guarantee higher returns.
- Risk tolerance and risk capacity are important considerations.
- Diversification and asset allocation may help manage risk but cannot eliminate it completely.