Investment Risk Factors
What is Investment Risk
Investment risk can be defined in different ways but in general, investment risk is the probability or likelihood for the occurrence of a loss relative to the expected return on any particular investment.
Risk is an important consideration in the assessment of different investment opportunities and while many investors believe that a lower risk investment may be a good investment, a higher risk investment will often provide a higher return.
Types of Investment Risk
- Market Risk (Systemic Risk)
- Unsystemic Risk
- Equity Risk
- Interest Rate Risk
- Currency Risk
- Commodity Risk
- Liquidity Risk
- Concentration Risk
- Credit Risk
- Reinvestment Risk
- Inflation Risk
- Longevity Risk
- Horizon Risk
- Foreign Investment Risk
- Valuation Risk
- Volatility Risk
Market Risk (Systemic Risk)
Market risk or systemic risk is the risk or probability of investments declining in value because of economic developments or other events that affect the entire market or market segment. Price volatility often arises due to unanticipated fluctuations in factors that commonly affect the entire financial market.
Key sources of market risk include changes in interest rates, political turmoil, recessions, natural disasters and terrorist attacks. Exposure to market risk cannot be avoided or taken away through diversification, which is why it is also known as undiversifiable risk.
Unsystematic risk is the risk which is unique to a specific company or industry. Exposure to unsystematic risk can potentially be reduced through diversification. Once diversified, an investor is still subject to market-wide systemic risk.
The total risk of investing is the combination of the unsystematic risk plus the systemic risk. Unsystematic risk is also known as diversifiable risk, non-systematic risk, specific risk or residual risk.
Equity risk is the risk or probability for loss in holding equity or shares of stock in a specific investment. The market price of shares will change frequently depending on supply and demand so there is a risk of loss if there is a drop in the share price.
Equity risk premium is the rate of return required by an investor to take on a higher risk equity investment. It is defined as the excess rate of return that is earned when a person invests in an equity security as compared to a risk-free rate.
Interest Rate Risk
Interest rate risk is the risk or probability for a loss in an investment when there is a change in interest rates. An increase in interest rates will usually have an adverse effect on the value of a debt security, such as a bond, as fixed-income investments are sensitive to changes in interest rates.
Bonds with a shorter time to maturity carry a smaller interest rate risk as compared to bonds with longer maturities. Long-term bonds carryy a higher probability of interest rate changes, which is why they carry a higher interest rate risk.
Currency risk is the risk or probability for loss due to a movement in the exchange rate of a currency relative to another currency. It is an exposure that an investor will face on foreign investments or investments where companies are returning profits, earned from abroad, back to the home country.
As an example, if the US dollar declines in value relative to the Canadian dollar, US stocks will be worth less in Canadian dollars. A currency is sensitive to a country’s inflation and economic confidence, which can influence exchange rates. Currency risk is also known as exchange-rate risk.
Commodity risk is the risk or probability for loss due to the fluctuation in prices of commodities. Commodity buyers face the risk that the commodity price will be higher than expected, which may contribute to an economic loss.
Commodity producers or sellers face the risk that the commodity price will be lower than expected. It is common for investors with significant commodity exposure to use commodity hedges or derivatives to offer a level of protection from uncertainties.
Liquidity risk is the risk or probability of being unable to sell your investment at a fair market price and get your money out when you want to. The risk occurs in situations where an investor is interested in selling but unable to do so since no other investor in the market wants to buy.
The investment cannot be traded quick enough in the market without impacting the market price. To sell the investment, the party may need to accept a lower price and, in some cases, such as exempt market investments, it may not be possible to sell the investment at all.
Concentration risk is the risk or probability of loss due to an exposure or dependence on a single investment. Since there is no diversification, an adverse move in the investment price can generate a loss.
When diversification is applied to investing, the risk is spread over different types of investments, industries and geographic locations, which reduces the concentration risk.
Credit risk is the risk or probability that a company or a government, who issued the debt security or bond, will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity.
An investor can evaluate credit risk by looking at the credit rating of the security. As an example, long-term US government bonds have a credit rating of AAA, which indicates the highest of creditworthiness and the lowest possible credit risk.
Reinvestment risk is the risk or probability that an investor will be unable to reinvest the cash flows received from an investment at a rate that is equal to or comparable to the current rate of return. While reinvestment risk is most commonly associated with bonds, it can apply to any cash-generating investment.
Callable bonds or a bond with a sinking fund provision are especially vulnerable to reinvestment risk since these bonds are typically redeemed when interest rates decline.
Inflation risk is the risk or probability of loss in purchasing power because the value of the investment does not keep up with the rate of inflation. Inflation erodes the purchasing power of money over time, which means the same amount of money will buy less of a good in the future.
This type of risk is particularly relevant to fixed-income investments, such as bonds, as a fixed rate of return will become less valuable each year with rising inflation. Variable-rate securities offer some protection against inflation as their rate will adjust periodically based on indices.
Longevity risk is the risk or probability of outliving your financial resources or savings. This risk is particularly relevant for people who are retired or are nearing retirement.
There is a chance that life expectancies and actual survival rates exceed expectations, which results in a greater-than-expected cash flow need from investments or retirement accounts.
Horizon risk is the risk or probability that the investment time horizon may be shortened because of an unforeseen event, which may force a sale of an investment at an inopportune time. If sold when the investment or market is down, there could be a loss.
Foreign Investment Risk
Foreign investment risk is the risk or probability of loss when investing in securities of foreign countries. Investing in other countries can provide diversification but it may also come with higher transaction costs, currency volatility and liquidity issues.
Valuation risk is the risk or probability of loss due to a difference in the accounting value of the investment and the market value. The investment may be overvalued and worth less when it matures or is sold. The risk can be significant for financial instruments or derivatives with complex features and limited liquidity.
Volatility risk is the risk or probability of a change in price due to changes in volatility. Option prices are influenced by changes in volatility. Vega is the measurement of an option’s price sensitivity to changes in the volatility of the underlying security.