Investment risk is the level of unpredictable financial loss in an investment. All investment decisions are inheritably risky, but certain types of investments pose more uncertainty than others.
How Do Investors Protect Themselves from Risk?
Investing is a great way to build wealth. Investors essentially make money from money, as they provide funds to companies and other business entities with the hope they can get a more significant return. But how do investors protect themselves from financial risk?
Investors manage investment risk through:
- Risk management strategies
- Diversification of investments
Using a risk management strategy can help a business address risks in a certain way. On the other hand, diversification helps an investor split up their money to prevent a complete financial loss.
There is no singular investment strategy that works for every investor. The best method to reduce risk depends on the industry and the potential risks involved.
What Are Some Examples of Risk Management Strategies?
Risk management is the process of identifying, analyzing, and reducing uncertainty in investment decisions. Various risk management strategies can be implemented.
Adopting a risk management strategy can help a business reduce the impact of financial risk. There are different strategies available to help businesses deal with various consequences. While a company can only use one risk management strategy at a time, it is better to use multiple methods. A business should also continuously assess risks and change strategies to identify and respond to risks in a timely manner.
The best risk management strategy depends on the business or industry. Learn about five common strategies below:
Risk Avoidance
Risk avoidance is the act of trying to avoid the possibility of risk. Businesses try to eliminate financial risk by changing certain practices or preventing specific activities. Risk avoidance strategies must change periodically since issues change and materialize over time.
Risk Acceptance
Risk acceptance, also known as risk retention, is when a business does nothing to prevent the risk of loss. This strategy is ideal for large companies that can afford to deal with unforeseen financial risks. The risk acceptance strategy is often used in combination with other approaches.
Risk Transfer
Risk transfer is when a business shares risks with other parties. A business can redistribute risk to company members, insurance companies, partners, or outsourced entities. A risk transfer is ideal when the financial risk is low, but the impact can be potentially significant. One way a business can implement the risk transfer strategy is to sign contracts with suppliers or contractors.
Risk Reduction
Risk reduction, or mitigation, is the process of minimizing the probability of financial risk. Businesses look for ways to reduce the severity of consequences to the residual risk level. Residual risk is the risk that remains after proper precautions have been taken. One example of risk reduction is when a company introduces strict safety measures.
Risk-Retention
Risk-retention is a controversial risk management strategy because the business acknowledges and accepts the risk. This strategy is often used when a company wants to offset more considerable financial risks in the future. For example, a business may choose to accept shoplifting losses instead of claiming a crime insurance policy. Suppose the value of the inventory loss is lower than the policy deductible. In that case, implementing the risk retention strategy may be the cheaper option.
What is Diversification of Investments?
Diversification is an investment strategy that can help prevent a total loss for investors. When an investor puts all their money toward only one type of investment, they can lose everything. In other words, it’s best not to keep all your eggs in one basket. But investors can split up funds among various types of investments to reduce investment risk!
Learn about various types of investment options below:
Stocks
A stock is a type of security that allows investors to own a share of a publicly-traded company. Stocks are also known as shares or equities. Investors can buy a stock through an online stock broker such as Charles Schwab. The amount of money an investor needs to start buying stocks depends on the brokerage and the cost of shares.
Bonds
A bond is a debt security that is equivalent to an IOU. When borrowers buy bonds, they lend money to a business or government entity. For example, you may purchase a Treasury bond from the federal government. An investor gets interest payments during the repayment period of a bond. Bonds typically offer lower returns than stocks but provide more consistent payments.
Mutual Funds
A mutual fund is a pool of investor funds used to buy investments such as stocks and bonds. Mutual funds are either actively or passively managed.
- Actively Managed Fund: This type of fund has a fund manager that decides how investor funds are spent and invested. Fund managers try to outperform an index, such as the Consumer Price Index (CPI).
- Passively Managed Fund: This type of fund does not involve a lot of buying and selling. Investors track a major stock market index, such as the Dow Jones Industrial Average. A passively managed fund is also known as an index fund.
Certificates of Deposit (CDs)
A certificate of deposit (CD) is a low-risk investment option. Investors give a financial institution a specific amount of money and earn interest on the given amount. However, the money is not accessible for a predetermined amount of time. Suppose you keep $5,000 in a 5-year CD with a 5% fixed interest rate. In five years’ time, you will withdraw $6,382 after earning $1,382 on your initial investment.
Exchange-Traded Funds (ETFs)
EFTs, also known as exchange-traded funds, are similar to mutual funds. An EFT is a type of pooled investment that allows investors to buy multiple stocks or bonds in specific market segments at once. An EFT can help an investor earn money from a collection of returns. The price of NFT shares fluctuates throughout the trading day.
What Are the Different Types of Investment Risk?
Investing is a risk, as there is always the potential of losing money. However, investors also have the potential to earn more than saving. The risk level an investor takes differs depending on the investment product. Read about various investment risks below:
Business Risk
Stocks and bonds are two standard investment products that rely on the continuing operation of a company. But suppose a company files for bankruptcy and liquidates assets. In that case, common stockholders risk losing their investment since they are a low priority for repayment.
Volatility Risk
Volatility risk is essentially the risk of change. For example, stock prices continuously fluctuate. If an investor buys stock shares, they are taking on vitality risk because they know the price of a portfolio can result in gains or losses.
Interest Rate Risk
Interest rate risk is the risk of interest rates increasing exponentially. For example, interest rates directly affect bonds, a popular investment product. Investors are more likely to acquire newly issued bonds if interest rates rise. However, older bonds with lower rates may have to be sold at a discount. Interest rates rise due to inflation as well as supply and demand.
Inflation Risk
Inflation risk is the risk of prices for goods and services increasing. Investment risks rise when increasing rates outpace the returns on investments. Inflation risk is also known as purchasing power risk because inflation results in less purchasing power.
Liquidity Risk
Liquidity risk is the risk that an investor will not find a market for their securities. For example, liquidity risk prevents investors from buying or selling exactly when they want to. Liquidity risk is expected with investment products that charge penalty fees for early withdrawal or liquidation, such as certificates of deposit.
Currency Risk
Currency risk is a risk investors face when they participate in cross-border transactions. Operating in foreign countries is risky due to unpredictable gains or losses as a result of changes in the value of one currency in relation to another. Investors who want to buy shares of companies in emerging markets have to contend with currency risk.
Concentration Risk
Concentration risk is the risk of financial loss due to a large dependence on one individual vendor, geographic area, or investment portfolio. The concentration risk is higher when a lender’s loan portfolio lacks diversity. Investing in various investment products will lower the concentration risk.
Credit Risk
Credit risk is when a financial institution lends money to a borrower that may not repay the loan. Many lenders base loan eligibility on a borrower’s level of credit risk. Bad credit borrowers typically have difficulty qualifying for loans because they are a credit risk.
Market Risk
Market risk, also known as systematic risk, is the possibility of financial loss due to the overall performance of investments in financial markets. The market risk increases due to fluctuating interest rates, exchange rates, recessions, or geopolitical events. For example, investors face market risk when the market value of a financial product decreases. If the price of a stock continuously falls, the investor will lose money if they sell. But selling may be the right option if the price never increases again.
Reinvestment Risk
Reinvestment risk is the probability that an investor will not be able to reinvest money from another investment. The level of reinvestment risk depends on the investment product. For example, the reinvestment risk is low with certificates of deposit because they are federally insured for up to $250,000 by the Federal Deposit Insurance Corporation (FDIC).
References:
What is Risk?│U.S. Securities and Exchange Commission
5 Examples of Risk Management Strategies│Techslang
10 Common Types of Investments and How They Work│SmartAsset
Types of investment risk│OSC INVESTOR OFFICE
Investment Risk│WallStreetMojo