Risk and evaluating risk are part of your everyday decision making, no matter how small the decision. Going on holiday? What are the risks of flying vs driving? What about the country you are visiting, is it safe? How about deciding on what to eat and where to buy your food from? We research different aspects of our everyday to understand what risks we are taking almost unconsciously.
Similarly, there are always risks associated with investing. The objective of investing is for your money to grow over time. However, investment decisions can lead to a bumpy road, some of which may not be recoverable, which is why understanding investing related risks is key to an investor journey.
There are many different types of risk associated with investing. A quick google search will reveal a huge list of different categories, types, subtypes etc. This blog is meant to highlight some of the most common types of risk with examples of how it has impacted investors in recent times. Please note this is not an exhaustive list, but what we deem to be an important list.
You can broadly categorize all types of risk into two major categories: systematic and unsystematic risk.
Systematic risk is a risk that affects the whole market or market segments/sectors. Examples include natural disasters, weather events, war etc... Systematic risk is beyond the investor’s control.
Unsystematic risk is a risk associated with a particular industry or stock. It can be mitigated through diversification, and the investor has much more control over these types of risk as it is limited to companies, industries, and specific assets.
This is the risk you take knowing that the overall market could go down, which will cause your investments to lose value.
Examples of market risk were the 2008 Global Financial Crisis and the Covid-19 pandemic. These were large scale disruptions to the market that affected global economies and multiple sectors.
This is the risk you take when investing in a different currency. If the value of the currency in which your investments are denominated changes it could cause your investments to lose value.
Let's say an individual investor residing in the United States decides to invest $10,000 in a foreign stock denominated in a different currency, such as the Euro. With the exchange rate at 1 Euro = 1.20 USD, the investor would have purchased approximately 8,333 Euros of the foreign stock. However, if the value of the Euro declines relative to the US Dollar (the $ gets stronger), and the exchange rate changes to 1 Euro = 1.10 USD, the $ value of the investor's investment is now only $9,166.30.
So even without the stock price moving, the investor has lost money because of the currency change.
This is the risk that the prices of goods and services will increase, which could erode the value of your investments.
One example of how inflation risk can affect individual investors is if they have bought a bond. Typically, people look at bond investments to derive an income from the regular coupon payments.
Let’s say someone invested $100k in a bond which paid a fixed annual coupon of 5%, because they wanted to get $5k a year to cover $5k of expenses. When inflation was recently near zero, the coupon payment would cover their needs.
However, if inflation soars, then the $5k a year coupon may not be enough to now cover the expenses as they would have gone up beyond $5k because of inflation.
This risk is associated with political events, such as war or a change in government, which could negatively impact your investments.
One example of political risk was the Brexit vote in the UK whereby a previously considered unexpected result caught markets unaware and the FTSE 100 fell over 7% the day after the vote.
This is the risk that a company might default on its debt, which could also cause your stock investments to lose value.
An example of credit risk was in January 2023 when Bed Bath & Beyond announced that it had defaulted on its loans and couldn’t repay its debts, followed immediately by the company missing interest payments on around $1 billion of bonds. The result was a drop in stock price of close to 90% over the following months, causing a large loss of money for its investors.
This is the risk associated with your ability to sell your investments in a timely fashion when you need to.
For example, if you invest in a small, illiquid company, it may be difficult to sell your shares if you need to raise cash quickly. Although investing in start-ups and new companies can be exciting, illiquid companies can carry the risk of limited buyer interest and challenges in finding willing buyers when selling shares. The liquidity of a stock depends on factors such as trading volume, market demand, and the company's overall attractiveness to investors. In times of urgency or market downturns, it can become more challenging to sell illiquid stocks quickly at desired prices.
This is the risk that something could go wrong with the company you are investing in, such as a scandal or a natural disaster.
In 2017, Equifax, one of the largest credit reporting agencies in the United States, experienced a significant data breach. The breach exposed sensitive personal information of approximately 147 million consumers. This incident resulted in operational and reputational risks for Equifax.
Following the disclosure of the breach, Equifax's stock price fell by approximately 35% from its pre-breach levels. The breach generated significant media attention and raised concerns about the company's data security practices, leading to a loss of investor confidence.
Investing is a great way to grow your wealth over time. However, it is important to remember that there is no such thing as a risk-free investment. By understanding the risks, you can develop a strategy to manage your risk, weather the bumpy road and reduce your chances of losing money and increase your chances of achieving your financial goals. It is important for investors to consider and research strategies to mitigate risk, some of which are doing proper research, diversification, and regularly evaluating/reallocating your portfolio.
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