Risks of Investing
Investing when starting out can be scary, you hear all the time about the risks of investing. But in this article, we shall break down 7 of the risks into simple categories. Being aware of these risks of investing will help you become a better investor.
The 7 risks of investing:
- Market risk
- Liquidity risk
- Concentration risk
- Credit risk (Bonds)
- Inflation risk
- Horizon risk
- Foreign investment risk
But what are these risks and what do they mean? At first, this may seem worrying but these are easy to understand and by setting rules when you invest you can avoid or minimize the risk to suit your appetite.
With market risk, there are 3 identifiers when looking at this. We have equity risk, interest rate risk and currency risk.
With equity risk, this applies to an investment into individual shares. As the market price of these shares fluctuates over time, depending on supply and demand, we risk dropping the share price over the short term. This results in the risk of a potential paper loss.
Secondly, we have interest rate risk, this type of risk applies to investments such as bonds. If the interest rate goes up we find the market value of a bond goes down.
The third is currency risk. This applies when you hold foreign investments. This risk comes from the difference between two currencies which is known as the exchange rate, also abbreviated to FX (foreign exchange). For example, if the U.S dollar (USD) becomes more valuable relative to the Great British Pound (GBP) as a UK investor any US stocks in the portfolio will depreciate in value when converting USD to GBP.
When talking about liquidity with investing it’s relevant to how available are shares to buy and sell. If the liquidity of a specific investment is low, this can result in it becoming difficult to sell your asset and mean you may need to accept a lower price than was originally wanting to sell for.
Concentration risk comes down to how diversified your portfolio is. Like the saying don’t hold all your eggs in one basket, much the same as investing. You want to spread your risk over different types of investments, industries and geographic locations.
Credit risk is a risk which affects bonds mostly. There is a risk that a government entity or company that issued the bond will run into financial difficulties and won’t be able to pay interest or repay the principal upon maturity of the specific bond. Each company and government are given a bond rating and show how credible they are. AAA rating indicated the lowest possible credit risk.
As mentioned earlier about inflation, it adds the risk of losing purchasing power. Not only can you lose purchasing power with your cash but it also devalues your investments if they do not keep up with inflation itself. Inflation risk is not only for the investing world, it also affects cash savings or debts, whether personal debts or investments like bonds.
Investing comes with two sides of the coin, you can under or overperform inflation by choosing suitable investments. Savings, it is determined by the interest rate and as of 2021, you are very unlikely to find an interest rate beating inflation.
|Inflation||Saving Interest||Stock market returns|
|1%||Easy access 0.57%||FTSE100 YTD 4.3%|
With these numbers alone we can see with savings we would have lost 0.43% purchasing power, compare this to the FTSE100 YTD return we would have gained 3.3%. That’s a difference of 3.73% between saving and investing.
The risk that your investment horizon may be shortened by an unforeseen event, for example losing your job. This may force you to sell investments that you were expecting to hold for the long term. If you are forced to sell at a time when the markets are down, you may lose money. A way to combat this is to create an emergency fund which we talked about previously.
The 7 risks of investing
Knowing these 7 risks of investing will help you to become a better investor.
While many of these are unavoidable to the normal investor, what we can do is reduce these risks and limit the possible downsides of our investment journey.
Concentration risk and Horizon risk are two of the easier risks to avoid. these can be avoided when you put together a solid investment strategy. Including goals, time horizon and type of strategy/portfolio you will be investing into.
For example, you can have a goal of retirement, using a LISA or SIPP account are some of the most tax-efficient accounts for this specific goal. Knowing that you are saving for retirement you are then able to figure out how many years you have till you reach your goal.
Working this backwards you can play around with compound calculators to see how much your account could grow depending on varying regular deposits into the account. Knowing that it will be for a long period of time you may wish to opt for a simple investment like a world tracker fund. For example possible VWRL/VWRP.
These types of all-world tracking ETFs are already diverse.
A simple strategy but with this, you have limited two possible risks of investing.
Now you know the 7 risks of investing check out our article on the Psychological traps of Investing.