Investment risk: what is it and how does it affect you?
No matter what investments you choose for your portfolio, there will be risks you'll have to consider. Here's the thing though: not all risks are created equal. Understanding the risk levels that come with different asset classes is key to helping you decide what products are best suited for your current risk appetite and aspirations.
"There are risks in every investment you hold
Often have you heard that told"
What is investment risk?
Investment risk is simply the probability of incurring losses relative to the expected return on the capital you put into your investments. Different types of investment products carry varying risks, so when you're deciding what to invest in, you first have to consider what your risk appetite is like.
Think of the risk you're taking when you're hanging off a climbing crag at Lion Rock with your bare hands, hundreds of metres above ground. And then compare that with the risk of climbing an indoor wall with cushioned mats below.
Does hanging off a cliff sound like the best day ever? Or do you prefer the security of a climbing gym? Or maybe you've got a fear of heights and being anything higher than 1 floor up scares you?
The point is: everyone has a different risk tolerance and the same principle applies to investment risk. If there's a secret to investing, it's that you need to come to terms with the risks – and also the potential returns – involved.
You'll then be able to work out how much risk you're willing to take on and choose investments accordingly to help you clinch your goals.
Different types of investment risk
Here are a few basic types of risk you may encounter while investing:
Market risk is the possibility of experiencing losses due to factors affecting the overall performance of investments in the financial market. These include changing interest and foreign exchange rates, inflation levels, political instability or a global pandemic, which we saw in the form of COVID-19. These things affect most companies and the performance of their stocks.
It's ultimately quite challenging to hedge against market risks, and even diversifying your investments might not ward off the full impact of such over-arching macroeconomic factors.
Financial risk and business risk
Financial risk refers to a company's ability to manage its debt, while business risk involves whether the company will be able to generate enough revenue from its operations to cover all of its expenses. You can help mitigate both of these investment risks by diversifying your portfolio.
When investing, you can't have returns without risk. It's often true that the lower the potential risk an investment carries, the lower its potential returns; and the higher the risk, the higher the possible returns. Finding a good balance between the highest possible return and lowest possible risk will depend on your risk tolerance and how long you can hold your investment for.
4 basic investment tools and the risks they carry
Now let's move on to look at 4 types of asset classes to see which investment tools are more suitable for your risk appetite and financial goals.
1. Unit trusts
A unit trust will involve your money being invested in a diversified portfolio alongside other investors by a professional fund manager.
The risk levels for unit trusts vary from fund to fund, but generally, your capital (and your exposure) is spread over all of the different investments in the portfolio, instead of just one. You also have the choice of investing across a number of sectors, themes such as healthcare or tech, or even a specific country/region or group of countries/regions.
2. Foreign exchange (FX)
FX investments essentially involve transactions in different currencies, where your returns depend on exchange rate movements. It's the world's largest market, carrying enormous liquidity, with an average of well above USD6 trillion being traded daily.1
Exchange rates are impacted by constantly changing macroeconomic and global sociopolitical factors. Is the currency you're investing in pegged to another, like the US dollar? It could then be impacted by what happens in that country, so you'll have to monitor for the effects of elections, quantitative easing and other events that happen there.
Securities are tradable financial investments that carry monetary value, such as stocks, bonds, mutual funds and exchange traded funds (ETFs). Generally, there are 2 types of securities – equities and debt – and hybrid securities that are a blend of both.
Investing in securities brings with it market risk – take stock prices that could move up and down for instance. There are also business risks associated with the companies behind these securities – an announcement of a CEO stepping down might push share prices down, while a confirmed takeover by a reputable buyer may see prices climbing.
Bonds are investments where you loan money to a corporate or governmental bond issuer, who then use capital raised from bond offerings to fund their operations or to purchase assets. Bonds are a type of 'debt instrument' because issuers are obligated to pay back the amount you invested, plus a certain extra percentage.
Default risk and credit risk are always present with bonds. If the issuer of the bond doesn't default, then you'll receive the principal amount of the bond at maturity or during stipulated intervals. And if you pull the plug on your investment earlier than the bond's maturity date, there is also a risk you'll lose some of your investment.
When should you start investing?
Ultimately, it really depends on you! But something you should remember is the power of compound interest could really make a difference in your investment returns, so the earlier you start investing, the more potential returns you'll reap.
All in all, it's important to remember that every investment carries a level of risk, and you'll need to weigh out the risk-reward element carefully before deciding on the asset classes that are most suitable for your risk appetite and longer-term wealth goals. There is no one-sized-fits-all formula to investing, so it's important to consider your risk appetite and capital contributions carefully before starting your investment portfolio.