A Look at Investment Risk
- Reviewed by: Brian Stormont, CFP®
- May 12, 2021
All investments have some degree of risk, and whether it is individual stocks, mutual funds, exchange-traded funds, bonds or real estate, there is always the potential an investment can lose value. Generally speaking, the more risk associated with an investment, the higher the expected return for that investment will be. Many types of risk can be reduced through proper diversification and other means. Below, we discuss some of the types of risk that can impact your investments, ways to mitigate some of that risk and why it is important to understand your risk tolerance, risk capacity and investment time horizon when determining which investments are suitable for your unique situation.
Investments in stocks and other equities can be negatively affected by market risk, potential losses investors can experience from factors influencing the overall performance of financial markets. Also known as systematic risk, market risk is what investors are exposed to when investing in financial markets. The sources of market risk impact financial markets as a whole and can include economic recessions and depressions, natural disasters, terrorist attacks and political turmoil. This type of inherent risk cannot be eliminated through diversification.
Interest rate risk is related to changes in interest rates. This type of risk can have an impact on investments like stocks, but it is a significant risk to fixed-income securities including bonds. Bonds issued at a certain price will be less attractive to investors if interest rates rise. To make them appealing to investors, the bonds need to be discounted so the return can compete with what investors could receive on the current market. This is because the investor will be able to get the higher rate with a new bond. Conversely, if rates fall, a bond offering a higher rate than a newly issued bond can sell at a premium. Investors can mitigate interest rate risk with products like options contracts.
Credit Risk stems from the possibility a borrower will default on a loan, exposing the lender to a loss of the interest and/or principal associated with that loan. Credit risk also extends to bonds, because the company or government issuing a bond could potentially default on what is basically a loan from the investor. Investors can limit their exposure to credit risk by investing in companies or government entities that are highly rated by reputable agencies.
Many investors prefer to include assets such as real estate in their portfolio. Real estate and other types of illiquid assets are subject to liquidity risk, because these types of assets can’t usually be sold quickly at market value. Investors can protect themselves from liquidity risk by ensuring they have adequate cash and cash equivalent assets to cover short-term financial needs.
Additional types of risk include currency risk, which applies to changes in the price of currencies in relation to each other, political risk, which is the impact the political climate of a country can have on markets, and call and reinvestment risk, which is often associated with callable bonds.
Understanding Risk Tolerance, Risk Capacity and Time Horizon
Before deciding on which investments are most suitable to help you meet your financial goals, it is important to understand how much risk you are willing and able to take. Determining your risk tolerance, risk capacity and time horizon are critical tools in helping determine the allocation of your assets.
Risk tolerance is related to the level of market risk an individual is willing to take. Some individuals have a difficult time stomaching market volatility and would prefer exposure to less risk, even if that means lower return potential. Others may be comfortable with more volatility and risk if that means their investments have a higher potential for greater returns. For example, someone with an aggressive risk tolerance may be more suited for investments in stocks and equities markets while someone with a conservative risk tolerance would find bonds and other fix-income investments more suitable.
While risk tolerance helps identify how much risk an individual is willing to take, risk capacity helps identify how much risk an individual needs to take to reach certain financial goals. An investor may have a higher risk tolerance but may not have the appropriate income or financial resources to match. Risk tolerance and risk capacity work together in helping to determine the makeup of an investor’s portfolio.
An investor’s time horizon relates to the time before the investor will need to access his or her money. Generally speaking, the longer the time horizon, the more aggressive the investor can be with their asset allocation. Investors with shorter time horizons generally may be more suitable for less risky investments. An investor’s time horizon can vary depending on the timeframe of the goal. For example, assets put aside for a new home purchase next year will have a much shorter time horizon than assets invested for retirement 30 years from now.
Completing a risk tolerance questionnaire is a good way to help determine and understand an individual’s risk tolerance, risk capacity and time horizon. The questionnaire will also present certain market situations and asks the investor how they would respond to certain scenarios. For example, the questionnaire may inquire about the investor’s response if there was a 20% drop in the market. An aggressive investor might decide not to act, a moderate investor might decide to wait a bit before acting, and a conservative investor might want to sell immediately.
Insight Wealth Strategies, LLC (IWS) and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
