Major Types of Risk Involved in Investing

The major types of risk associated with investing are market value risk, inflation, and economic risk. These should be factored in when deciding on investment instruments to include in your portfolio.

Market value risk is naturally related to the performance of the market. What happens to your investments when the market ignores or turns against them is known as market value risk. If the market is after new hot investment opportunities, many unexciting but good companies are left behind. The same is true if the market collapses. Investors withdraw from the market, opting out of bad and good stocks.

Inflation is another factor to watch for – it creates recessions and destroys the value of investments. Many believe that inflation is under control, but with huge government debts, intended to stimulate economic growth, inflation is about to make a return. Historically, precious metals and real estate, which are hard assets, have been preferred investment instruments in times of inflation.

Economic risk is one obvious risk to consider, meaning that the economy can go bad. In this situation, i.e. when the market is in dumps, investors often turn to foreign stocks. With globalization, many companies are earning their profits oversees. Note that you are in a tighter bind, if you are an older investor. Being near or in retirement, a downturn in stocks may turn devastating, especially if you do not have assets in the form of fixed income securities and bonds.

Of course, a lot depends on the level of risk you are willing to take. It pays to be a careful and conservative investor in some cases, but not taking any risk may make it impossible to attain your financial goals. Other types of risk are liquidity risk, interest rate risk, and exchange rate risk. Fluctuations in exchange rates pose one risk because they can adversely affect the value of an investment instrument. Investing overseas is a good way to diversify your portfolio, but changes in the exchange rate of the Canadian currency against the one where you invest will impact on the investment’s returns. Interest rate risk is another type of risk, with the value of investments changing due to interest rate changes. The latter have direct impact on bonds and other interest rate securities and their value. Changes in interest rates have an indirect impact on other investment instruments such as shares and property.

Liquidity risk refers to the risk that certain investment instrument will not be quickly and easily sold and bought. This means that they will not be easily converted into cash, with you getting a fair price. Finally, there is the counterparty or credit risk, meaning that counterparty to a contract may not keep up with their contractual obligations. In addition to these major types of risk, there are others: institutional risk, company risk, country risk, sovereign risk, and geopolitical or political risk. The latter refers to risk that the authorities will implement new regulations or change their policies, thus making certain investment instruments less attractive.

Sovereign risk refers to risk that central banks null or reduce the value of foreign exchange agreements and change their foreign exchange regulations. With country risk, there is risk that a country will be unable to meet certain financial obligations. Company risk is another type of risk for investors. Here, there is risk that the company you invest in may go out of business or incur losses. Institutional risk refers to insufficient capital to cover losses, failure in the risk management system, poor internal controls, and inadequate structures for governance. It also refers to the financial standing of a company or financial entity which makes investments on behalf of investors. The level of company, country, and institutional risk varies depending on the type of investment instruments and where you want to invest your money. In any case, it pays to diversify one’s investment portfolio as to reduce the level of risk involved.