One of the biggest fears that engulf everybody when they think of investing is the loss of their hard-earned money. A risk is inevitable as every investment involves some degree of risk or taking some calculated risk. It is believed that the higher the risk the higher the returns. A risk is the level of uncertainty that a particular investment will gain if you invest in it or the level of a potential financial loss that you are likely to incur if you invest in a particular asset. Every investor should be concerned about the investment risk as much as they are concerned about the possibility of returns. Investing requires understanding the level of risks involved. Here are risks that every investor should be aware of:
1. Business risk
Any business is exposed to uncertainties due to the economic downturns. A stockholder invests in the business when they purchase a portion of ownership in a company and a bondholder lends money to a business. If the business does not grow or do well and becomes bankrupt and its assets are liquidated, the common stockholders are among the last to get the proceeds from the dissolution. The bondholders are paid first, then the preferred shareholders and the ordinary shareholder gets the balance or the leftover which can be almost to or nothing. If you purchase individual stocks, you get exposed to business-specific risk and this can be reduced through asset diversification or buying a put option.
2. Market risk
Market risk is also known as the systematic risk and affects all securities the same way. Market risk is caused by a factor that cannot be mitigated through diversification.
3. Price Volatility risk
The stock price fluctuates up and down due to factors of supply and demand which are influenced by factors such as economic changes, changes in the company management. One way to measure volatility is the use of a beta and can approximate particular security returns against the returns of a benchmark such as S&P 500.
4. Inflation risk
Inflation is the general upward movement of prices and reduces the investor purchasing power or the purchasing value of money. Inflation risk is caused by the decline in value of the stocks cash flow due to inflation or the chances that the cash flows from an investment will not be worth as much in the future. You can mitigate this risk by investing in inflation-protected securities such as inflation-indexed bonds or Treasury inflation-protected securities (TIPS). You can mitigate this type of risk through purchasing appreciable investments.
5. Interest Rate risk
Interest rate risk arises due to fluctuations in interest rates and thus mostly affects the bond owners. A bonds measure of the interest rate risk exposure is determined by how sensitive its price is to interest rate changes in the market. The sensitivity depends on the bonds time to maturity and the coupon rate of the bond.
6. Liquidity risk
Liquidity risk is the risk that arises due to inability to convert a security or a hard asset to cash when desired without loss in capital or income in the process because of limited opportunities. A good example is difficulties encountered when selling a real estate property at any given moment should an urgent need arise. An individual investor, a company or a financial institution is thus incapable of meeting short-term financial obligations.
7. Political/Social/Legislative risk
These are risks that may occur due to the instability in the country due to the political environment, social changes or unfavorable government actions.
8. Currency/Exchange risk
This is a risk that an investor is exposed to due to changes in the price of the currency against another.
Investors should take risks that they can afford and look for ways to mitigate the risk that their securities are exposed to.