What is risk?
Risk is the possibility of loss, injury, or negative outcome. We all face a degree of risk every single day. Every time you get into a car you are making a decision with an element of risk. While the risk may be minor, it is not insignificant. Roughly 6 million car crashes happen each year in the United States. Speed-related accidents in 2019 alone – which account for only a fraction of those 6 million accidents – cost Americans upwards of $40.4 billion dollars.
Despite those statistics, most of us don’t think about risk when we hop in the car unless it’s a bad weather day. A majority of us simply focus on the things we can control, such as ensuring we are awake, alert, and attentive while behind the wheel.
Another example is the game we all play rationalizing best-buy, sell-buy, and expiration dates on food that we really want to eat. That expired pack of Oreos in the pantry is worth the risk when you really have a hankering, right? Expired yogurt, on the other hand, maybe not.
What is investment risk?
In the context of investing, risk is the possibility of not realizing the expected returns on your investment. That may mean you expected a return of 10% on your investment, and instead you only received a return of 4%. It could, of course, be much worse. You could see no return or even a negative return which would leave you with less money than you started with.
Risk is an important concept to understand in investing. Investors need to understand that all investment decisions incur a degree of risk. Even the ‘safest’ investments have risk in the form of opportunity cost (more on that later). However, not all risk is created equal, and there are a number of risk factors that will affect your investment decisions.
As we mentioned, there are numerous risk factors which can affect the overall risk of your investments. It’s important to understand what each type of risk entails. Some can be mitigated, some cannot.
Systematic Risk (aka “Market Risk”)
Market risk refers to the inherent risk that comes along with investing which can’t always be counteracted or foreseen.
1. Interest Rate Risk
If you invest in debt securities, such as bonds, you may be susceptible to interest risk. Debt securities (like bonds), as opposed to equity securities (like stocks), entitle bond holders to returns in the form of interest payments. Those returns could drop due to a change in interest rates.
2. Inflation Risk
Inflation risk also typically applies to debt securities. This type of risk is the potential for a loss in purchasing power. Bonds and other debt securities are traditionally lower-return investments which may not keep up with the pace of inflation. Over the last 100 years, the US inflation rate has averaged approximately 3% a year. If your bonds produce a rate of return less than inflation, then your investment will theoretically lose purchasing power over time.
3. Currency Risk (aka exchange rate)
If you invest in foreign markets, you may incur a level of risk due to fluctuations in the value of your currency versus the value of the foreign country’s currency you’re investing in (i.e. exchange rate). For example, say this year the US dollar is worth more than the Canadian dollar and you choose to invest in the Canadian market. Next year, perhaps the Canadian dollar is more valuable than the US dollar and therefore when you cash in your investment, it’s actually worth less due to the unfavorable exchange rate.
4. Equity Risk
Just as stock prices go up, they can also go down. Whether it’s because of the state of the economy, individual business practices of the company you bought shares of, or a number of other unforeseen, speculative reasons, stock prices fluctuate. “Buy low, sell high” is easier said than done.
Unsystematic risk, as opposed to systematic (or market) risk, can be mitigated (to an extent) through smart investment decision making, planning, and diversification.
5. Liquidity Risk
Liquidity risk is the risk that you may not be able to sell off your investments quickly at a fair market price. For example, stocks are typically more liquid investments than real estate. If you need to cash in an investment quickly, you’re more likely to be able to do that and retain your earnings through a more liquid investment like stocks, than you would by trying to sell a piece of real estate.
6. Concentration Risk
Concentration risk is the risk that you incur from being too heavily invested in a particular sector or industry. For instance, if you are solely invested in biotech companies and that industry suffers from increased regulation which drives down profits, your investment will suffer more than a diversified portfolio would.
7. Horizon Risk
Horizon risk applies when you cash out of your investments earlier than planned. Investment risk increases as your time horizon gets closer. If you decide to divest your funds earlier than you had intended to, you’ll forfeit potential future earnings, as well as take a hit if you are forced to sell while the market is down.
8. Longevity Risk
Longevity risk encompasses the risk that you could outlive your own expectations and therefore deplete your retirement investments before you planned to.
9. Foreign and Emerging Market Risk
Emerging markets in foreign countries can be appealing due to the amount of growth potential. However, they also carry risk if those emerging markets exist in countries that are less than stable – either politically or economically.
Opportunity Cost: the risk of not investing
If all of those risks have left you feeling wary, don’t quit reading yet. One of the lesser talked about risks is the opportunity cost of not investing.
Investing your hard earned money can seem intimidating, but take a moment to think about whether or not it would be feasible for you to simply save your way to retirement without investing. For most of us, this is simply not possible. Don’t believe us? Let’s do some quick math.
Because there are a number of variables that could impact these numbers, let’s make the assumption that you are 22 years old. To retire at age 65 and have $65,000 per year in retirement income, you’d need to accrue $1.6 million dollars. The average US household saves about $6,000 each year. So, if you save $6,000 per year, and simply leave that money in a savings account which pays out just enough interest to keep up with inflation (most do not), it would take you 267 years to save for retirement.
On the other hand, you could invest that money in something like the S&P 500. The S&P 500 has a historical return of 7%, adjusted for inflation. If you invested $500 a month ($6,000 a year) for 43 years starting at the age of 22, you’d end up with $1,774,393 assuming a 7% return.
So yes, there are risks when it comes to investing. But there are also risks to not investing. That is the opportunity cost. If you choose not to invest, your risk is the loss of potential, and likely gains, that you would earn had you invested. Drawing from our example above, that can add up to a tremendously large opportunity cost.
Ways to mitigate investment risk
So, now that we understand all the different types of risks, how do you go about making smart investment decisions that will support your financial goals? Fortunately, there are a number of ways that you can mitigate investment risk.
Diversification is key. Ensuring your portfolio isn’t concentrated solely in one type of asset class, industry or sector will help balance the booms and busts of one segment of the market. In simple terms, don’t put all of your eggs in one basket.
Dollar-cost averaging is a strategy of investing regularly with consistent amounts of money to use time to your advantage. This strategy also reduces a degree of volatility that you could see if you were instead to invest in a lump sum fashion.
Proper allocation is tremendously helpful to reduce risk based on your personal risk tolerance as well as your time-to-retirement horizon. Most commonly, this is done by adjusting the ratio of stocks to bonds in your portfolio.
Manage your own emotions
Remember that investing is a marathon, not a sprint. If your emotions are getting the best of you, try to remember this sage advice of Warren Buffett, “Be fearful when others are greedy and greedy when others are fearful.”
Hire a professional
Ensuring you are educated about your investments is key, but it is also a great idea to enlist the help of a professional. If you decide this is the best route for you, make sure you take the time to find an individual you trust, who is certified, and that they take the time to truly understand your goals.