Investment Risks: Understanding, Measuring, and Managing Them

By Marc Daner

Investing is an effective way to build wealth through passive income. Making money work for you by transacting with stocks, bonds, and other financial instruments can help you reach financial independence. However, while investing may sound appealing, it does not come without risks. 

Investment risks describe outcomes that diverge from what you expect. You can predict these risks based on past threats and results. But, a common trend you may see is that high-risk investments are more likely to gain higher returns. That said, losing a part of your assets from risky investments is also possible—a common occurrence in the investment landscape.

Learning how to assess investment risks is critical to minimize the chances of falling for them. This article will discuss common investment risks and how to manage them effectively to help keep your assets safe.

8 Types of Investment Risks

Horizon risk

Life's unpredictability is natural. However, sudden changes such as pregnancies, accidents, or unemployment can spell trouble for your assets. Horizon risks assume the possibility that these events may cut your investment time horizon short. You may start selling your investments to make ends meet, sometimes even with penalties or at a loss.

Protect your assets by building an emergency fund to support you during periods without sufficient income. A good practice is to set aside at least six months' worth of your necessary expenses, but even longer is better.

Inflation risk

Inflation is unavoidable, but the speed at which it occurs can significantly impact your passive income. You face inflation risk when price hikes outpace your investment's purchasing power. As a result, its value can end up less than what you have expected. Financial assets are more vulnerable to inflation risk, especially those with fixed rates, such as most bonds.

Consider choosing securities that directly address inflation risk to minimize its impact on your assets. For instance, Treasury Inflation-Protected Securities (TIPS) pay out principal sums with real returns or payments adjusted for inflation. Moreover, you may also hedge investments to offset the drastic decline in purchasing power.

Interest rate risk

Fluctuations in interest rates can also affect the value of investment instruments, with bonds being the most vulnerable. Higher rates cause the price of fixed-rate investments to drop. The drop reduces the chances of selling assets with good returns. Credit demand mainly influences interest hikes, as is often the case during financial crises.

Face rising rates head-on. Don't panic even if the economy plummets since most investments hold up well despite soaring interests. Don't fall for usual investing myths like "timing the market." Instead, think long-term and wait for your assets to get back on track while periodically adding to your portfolio. 

It's essential to consider and measure your duration if you invest in long-term bonds. As mentioned, prolonged high-rate periods tend to decrease the worth of long-term investments, and you won't want your bonds to lose their value.

Default risk

By lending money, you assume that debtors may not pay it back, even without interest. Unanticipated factors may hinder borrowers from paying their obligations, resulting in lenders and investors facing default risk.

Individual investors aren't the only victims of default risk. Companies that issue bonds but go insolvent can't realistically pay all their debts. Conversely, government bonds present one of the lowest default risks among other instruments. However, while the issuing government virtually guarantees interest payments, they generally provide low payouts with prolonged maturities.

You can determine default risk with standard measurement tools such as consumer credit scores (e.g., FICO) and credit ratings. Many independent organizations provide these metrics, including S&P Global Ratings, Moody's Investors Service, and Fitch Ratings. So, leverage their ratings to help you choose which entity to invest in. 

Business risk

When investing in a company, you assume it will remain in good business until you receive your profits. However, it's important to note that there is a possibility that a company can go bankrupt. When this happens, common stockholders—which may include you—get what's left of the assets, which is usually zero.

It's nearly impossible to eliminate business risk when the company's internal and external factors, like customer demand and the overall economy, can cripple their profits. 

Fortunately, you can minimize its effects with strategic risk planning. If you intend to invest in a business, research its historical financial strength and stay updated on its market performance. Doing so will help you make informed decisions.

Volatility risk

Despite trying to ensure your assets are safe with a company, regular stock price fluctuations still pose a risk. Internal and external factors influence price volatility, making it challenging to predict. 

However, you can still forecast volatility risk by studying stock price movements. It's also crucial to stand your ground and establish long-term goals during stretches of unpredictability.

Another way to measure volatility is by identifying its standard deviation, which shows the extent to which the stock diverges from its average price. Investments with high standard deviation suggest high volatility. In other words, there's a higher risk of losing investments and interest despite the greater chance of receiving good profits.

Foreign currency risk

It's not every day that exchange rates stay the same. Its fluctuations may give way to possible losses when trading in international markets. Any value growth or slump in the foreign currency you're investing in can affect both your principal and interest payouts. 

Moreover, this risk affects not only foreign investors but export/import businesses as well. So, it should be a primary consideration during any transactions with international markets.

Foreign currency risk has three main types:

Transaction risk arises when buying or selling with foreign companies.

Translation risk occurs when you convert foreign currency to your denomination with a loss.

Economic risk exists when the market value of the company you invest in is subject to currency fluctuations.

There are many complex approaches to measuring and managing foreign currency risk. One such approach is the widely used Value at Risk (VaR) model that assesses possible financial losses over a particular period. Investors also usually hedge other investments to balance the risk of currency instability.

Political risk

As mentioned, market fluctuations significantly influence your investments. You may even see this influence when dealing with highly erratic instruments like stocks. However, a significant player with tight control over market movement is the political landscape of the country you're investing in.

Take, for instance, the United Kingdom's decision to leave the European Union in 2016. The event has resulted in the value of individual savings account (ISA) investments in the country dropping by 5%. Meanwhile, UK investment values in foreign companies grew.

Other than the geopolitical climate, all government levels may impose taxes, regulations, valuations, and tariffs. These factors can affect investments for better or worse. Keep updated on the latest political news, especially concerning finances and securities, to get a heads-up on incoming changes.

Also, minimize investments in foreign countries with recent histories of government interference and political instability to curtail risks.

Manage Your Risk Appetite

You can see how little guarantee there is in growing your money. Investment risks lurk behind every corner, so it's critical to identify your risk appetite before entrusting your hard-earned money to any entity.

Determine how much you're willing to gain and lose based on your target returns and time horizon. If you prefer more significant payouts, you can choose volatile options while managing risks using the right approach.

It's a good practice to diversify your portfolio to maximize your profits. Placing your eggs in several baskets can minimize the impact of any obstacle that may arise in the market. Effective planning allows you to build wealth with minimal loss and reach your dream of financial independence.