After describing what risk is all about, it’s time to delve deeper into the fascinating world of investment risks. In this chapter, we’ll take you on a detective-like journey, unmasking the different types of investment risks and revealing what you should know about each one.
So, put on your detective hat, and let’s start our investigation! 🕵🏼
Our first suspect is market risk, a notorious figure known for wreaking havoc on all types of securities, including stocks, bonds, and mutual funds. Market risk is the potential for your investment to lose value due to broad market fluctuations, often driven by factors such as economic data, political events, and global crises.
For example, imagine you’ve invested in a company that makes electric scooters. If the entire transportation industry experiences a downturn, your scooter company’s stock could take a hit – even if the company itself is doing well. To keep an eye on this sneaky character, it’s important to stay informed about market trends and global events that could impact your investments.
(Not so) Fun fact: Did you know that during the Great Depression in the 1930s, the stock market lost approximately 90% of its value? 📉
Thankfully, market crashes of that magnitude are rare, but it serves as a reminder that market risk can be a powerful force.
Next on our list of suspects is credit risk, a crafty character that poses a threat to bondholders and other fixed-income investors. Credit risk arises when the issuer of a bond or other debt security fails to make interest or principal payments on time. This can result in a loss of income and potentially a decrease in the value of your investment.
Suppose you’ve invested in corporate bonds issued by a company that makes eco-friendly toothbrushes. 🪥 If the company struggles financially and can’t meet its debt obligations, you could be left holding the bag as a bondholder. To protect yourself from credit risk, it’s a good idea to research the creditworthiness of bond issuers and consider diversifying your fixed-income investments.
Fun fact: The term “junk 🗑️ bonds” refers to bonds with low credit ratings and a higher risk of default. These bonds offer higher interest rates to compensate investors for taking on the increased risk.
Interest rate risk
Our third suspect is interest rate risk, a master of disguise who can impact the value of bonds and other interest-bearing investments when interest rates change. If interest rates rise, the market value of existing bonds typically falls as newer bonds with higher interest rates become more attractive to investors. 🧲
For instance, let’s say you’ve invested in a 10-year government bond with a 2% interest rate. If interest rates suddenly rise to 3%, your bond will be less attractive to other investors, and its market value will likely decrease. To manage interest rate risk, consider diversifying your bond investments across different maturities and paying attention to central bank policies and economic indicators that can influence interest rates.
The “yield curve” 📈 is a graphical representation of interest rates across different bond maturities. An inverted yield curve, where short-term interest rates are higher than long-term rates, has historically been a predictor of economic recessions.
Inflation risk is our fourth suspect, a silent but dangerous force that can erode the purchasing power of your investment returns over time. As prices rise due to inflation, the real value of your investment returns decreases, making it harder for your money to keep up with the cost of living. Inflation Risk is particularly relevant for fixed-income investments like bonds, which may not generate returns that outpace inflation.
For example, imagine you’ve invested in a savings account that offers a 1.5% interest rate. If the annual inflation rate is 2%, the real return on your investment is actually negative, as your purchasing power has decreased. To combat Inflation Risk, consider diversifying your portfolio with investments that have the potential to grow faster than inflation, such as stocks or real estate.
An extreme example is Zimbabwe in 2008, where hyperinflation reached a staggering 89.7 sextillion percent per month! 🤯
While this extreme example is unlikely to occur in the UK and Europe, it highlights the importance of being mindful of Inflation Risk when investing.
Finally, we have liquidity risk, a slippery character that can make it difficult for you to sell your investment quickly and easily at a fair price. Liquidity 💦 risk is often higher in less liquid markets or for investments that are not widely traded, such as small-cap stocks, private equity, or real estate.
Imagine you’ve invested in a rare coin 🪙 collection that’s increased in value over time. If you need to sell the collection quickly to cover an unexpected expense, you might struggle to find a buyer willing to pay a fair price. To manage liquidity risk, ensure that your portfolio includes a mix of liquid and illiquid assets, and maintain an emergency fund to cover unexpected expenses without having to sell your investments.
Fun fact: The “bid-ask spread” is the difference between the highest price a buyer is willing to pay for an asset (the bid) and the lowest price a seller is willing to accept (the ask). A large bid-ask spread is often an indicator of higher liquidity risk.
As our investigation into the many faces of risk comes to an end, it’s clear that each type of investment risk poses unique challenges for investors. By understanding these risks and learning how to manage them effectively, you’ll be well-equipped to navigate the twists and turns of the investing world with confidence.
As you continue to learn and grow as an investor, you’ll develop the skills needed to tackle these risks head-on and build a diversified portfolio that’s tailored to your unique needs and goals. Coming up next… Which factors influence investment risk?