Types of investing risks

There are innumerable investing risks, so here is a bluffer’s guide to the main ones.

Next time you consider an investment, make sure you know which of these risks you’re taking, whether you’re comfortable with it – and whether you’re being offered a sufficiently attractive potential reward to compensate.

The presence of these risks does not mean an investment is a bad one. All investments have at least one of these risks.

What matters is whether price is right for the risk, and whether you understand what you’re getting into.

Note: These aren’t textbook definitions of types of investment risk. They’re meant to get the point across quickly to everyone, not stand up in a court of law.

Business risk

Sometimes used to refer to what I call ‘stock specific risk’ below: that is, the specific risks related to one company’s operations. Others use it to describe risks affecting all companies operating in a particular sector. For example, all fishing boats in the same port are affected by periods of bad weather, however skilled their captain or hearty their sailors. I think ‘sector risk’ describes that better.

Currency risk

The risk that comes through changes in the exchange rate between one currency against another. If you invest in European companies and the Euro collapses versus your currency, then your investment will be worth less in local terms when you bring the money back home (unless your funds are hedged, which costs). Similarly, your repayments on a foreign mortgage will rise as your currency weakens. Currency risk can work the other way of course, to your advantage.

Counterparty risk

This is the risk that someone you’ve entered into an agreement with will default or otherwise screw-up. It’s often not immediately apparent when you make the investment. For instance, the fancy Guaranteed Equity Bond your bank sold you might involve contracts underwritten by an American bank you’ve never heard of that goes bust. Don’t laugh – it happened.

Credit risk

Some people don’t pay what they owe. Nor do some companies. Sometimes even countries fail to cough up. If you’re a good credit risk, that means that banks and others think you’ll pay what you owe. If you’re a sub-prime borrower, they may be more concerned – unless you want a mortgage on a shack in a swamp in Florida in 2003-2007. Credit risk is sometimes called default risk.

Inflation

Ever increasing prices is the reason why nobody ever got rich from keeping money under the mattress (except perhaps the makers of mattresses) and the first reason to invest. It’s not just the low but steady inflation we’ve become used to in recent decades – and that you can plan for – that erodes your returns. If you’re very unlucky double-digit inflation comes out of the blue to crush fixed interest savings. Just ask the nearest German centenarian.

Interest rate risk

The risk that the value of your asset – usually a bond, but also to an extent stocks and other securities – will change in response to changes in interest rates. For instance, if you buy a long-dated corporate bond yielding 5% when base rates are 2%, it will very likely (but not inevitably) fall in price if base rates rise to 4%. A new purchaser would probably demand a higher yield (that is, would pay a lower price) to invest in the same corporate bond, given the risk-free rate was now 4%. A related risk is when you put cash in a fixed rate savings account, or take out a fixed rate mortgage. Your fixed rate will be less or more attractive as the base rate changes.

Liquidity risk

Liquidity is a measure of how easy or hard it is to sell an asset. Cash is very liquid; a house is illiquid. Some small company shares can be easy to sell – just log into your online broker and place the order – but if you try to sell more than the cost of a fancy sofa’s worth the price can plunge, which is another risk of poor liquidity. Money tied up for a year in a fixed rate bond is also illiquid, but that’s a given when you invest. You are accepting interest rate risk, and also the risk that you need your money before the term is up.

Management risk

When you invest in an actively managed fund or investment trust, you take on the risk related to the manager’s performance. He or she may do better than the market, or more likely worse. Using index tracker funds gets rid of management risk. The price you pay with a tracker (for most of us well worth it) is you’ve no chance of beating the market.

Market risk

This is the risk you take for simply showing up and investing in a volatile market. The stock market, the property market, even the market for antique hobbyhorses – all move in their own broad trends, which affect all the assets in that market. You can’t reduce market risk when hobbyhorse investing by buying two different hobbyhorses. But you could buy one hobbyhorse and spend the rest of your money on an antique sideboard. Market risk is sometimes called systemic risk – mainly by pompous people like me.

Political risk

There’s a reason why the Russian stock market usually trades on a lower valuation than Western markets, and why London-listed South African companies may seem cheap. The Russians are experts at the appropriation of private property, while South African companies operate in a beautiful country that politically appears to be going backwards.

Regulatory risk

Political risk for Western economies. The risk that politicians or other lawmakers introduce new rules or costs to an industry or sector that hurts your investment. The growing risk that we might see the election of the most left-wing UK government since the 1970s has hit the shares of energy companies, for example.

Stock specific risk

This is the risk that a particular company goes bust, even while the market sails on regardless, leaving your crappy shares in it floating lifeless in the wake. Companies can fall in price or go bust for all kinds of reasons, from fraud to poor management, though it usually amounts to running out of money. This sort of specific risk is also why fund investors (including passive investors) should spread their money between different companies as their portfolio grows. I even think you should keep some cash in different banks, even if your total balance is below the FSCS compensation limit. Assume anything can fail.

Volatility

In simple terms, volatility is the range over which the value of an asset moves over some time, usually a year (technically, the standard deviation over the return rate). If the price moves a lot, it’s a high volatility asset, whereas if it doesn’t go anywhere quickly, it’s low volatility. Low volatility usually seems more attractive, but higher volatility can deliver superior returns to compensate. Diversification can reduce volatility without denting returns to the same degree. It’s worth considering how closely – or not – academic notions of volatility mirror your own concerns as an investor. (Volatility risk has specific meanings, to do with options or currencies, beyond the scope of this article).

Remember, diversification is your best friend when trying to reduce investing risks. To learn more, please read my article for beginners about risk, returns, time, and diversification.

from Monevator http://monevator.com/types-of-investing-risks/