There is a 99.9% chance that you are on Facebook. This particular social network is quite necessary these days. We’re also pretty sure you know the owner and founder of Facebook, Mark Zuckerberg. The man has some wise words for all of us: “The biggest risk is not taking any risk. In a world that’s changing really quickly, the only strategy that is guaranteed to fail is not taking risks.”
Right you are, Mr. Zuckerberg. Sometimes all we need is to take chances. However, it is also important to be cognizant and calculate the risks we are taking.
What Is Investment Risk?
Risk is a situation with exposure to danger, harm or loss of something of value. It is the possibility that something bad or unpleasant will happen. Different investments have varying levels of risk. Some investors would tend to steer clear of those risks, but what they don’t know is that they’re also steering clear of potential investment returns by doing this.
The aggregate level of risk is a sum of various types of risk. Let’s discuss the different types of investment risk and how to sensibly mitigate them.
As the term suggests, market risk refers to the risk that the value of an investment will decrease due to factors that affect the overall performance of financial markets. Although stock market and real estate investments have been proven to increase your wealth, they’re exposed to a lot of factors that may cause the market to drop substantially. Did you know that in the period 1929 – 1932, the U.S. stock market fell by 89%? Ouch!
Market risk is also called systematic risk and cannot be mitigated or eliminated through diversification, but you can still protect your investment through hedging. Learn more about diversification and hedging in our articles: The First Thing You Need to Know About Diversification and Hedge Fund Strategies.
So how do you manage market-value risk? First, you need to consider your time horizon or the length of time you plan to invest. Historical data has shown that you lose money about once every three years if you invest in the stock or bond markets. However, stock and bond investors have been observed to have made money two thirds of the time in a span of one year. It’s also important to note that, historically speaking, market risk, especially for stocks and bonds, becomes less of a concern the longer you plan to invest.
Second, you may also want to consider avoiding “bloated” or overpriced investments. It is a common instinct to “buy low, sell high” but any investment “pro” will tell you, you can not and must not time the market.
Individual Investment Risk
Individual investment risk, also referred to as unsystematic risk, is that which is specific to your investment. It may be a stock of a certain company, a bond investment, or your own real estate. For instance, the stock market may be doing well on the aggregate but your investment in Company X may still fall due to factors specifically affecting the company or its industry. This could be a lawsuit against the company, poor earnings, or anything else that could negatively impact the company.
There are ways to combat individual investment risk, such as doing your research on a specific investment, hiring someone knowledgeable in the field to make investment decisions for you and of course, diversification. Unlike, market risk, individual investment risk can be eliminated through diversification.
Purchasing Power Risk
Ten years ago, a piece of chocolate bar cost about 40 cents, give or take. Now, the same chocolate bar will cost you almost a dollar! Why did this happen? The short answer is inflation or the general increase in prices of goods and services. And with inflation also comes a decline in purchasing power. Your 40 cents can not buy you the same things now as it could ten years ago.
Purchasing power risk, as it relates to investments, refers to the risk that the growth in your investments can not keep up with the increase in the cost of living brought about by inflation.
For most people, it is their career that enables them to earn money. If you lose your ability to earn, it will be difficult for you to produce money to invest as well. How does one lose their ability to earn? The job environment, whatever field it may be, is very competitive. That is why it’s so important to continually “sharpen the saw”, so to speak, by keeping abreast of new advances in your field and continually upgrading your skills.
It is true that risk is inevitable. However, with the right knowledge and strategy, you may take advantage of these risks to produce returns. The first step in mitigating risks is understanding them. Guess what? You just did. Let’s get to know the return on investment next.