What is risk?

Definition and Examples of Risk

Types of Risks

Do I Need to Take Risks?

What Does Risk Mean for Individual Investors?

Definition and Examples of Risk

In the investment world, risk generally refers to the possibility of losing part or all of a particular investment’s value. When investing, risk refers to the potential for the value of the investment to decrease rather than increase over time. Every investment carries different levels of risk. Bonds or certificates of deposit tend to be less risky than stocks, but all investments involve a certain level of risk.

For example, if you buy a share in a company, the value of that share can fluctuate, either increasing or decreasing. There is a risk that the stock price will decline after you purchase it. In the worst-case scenario, the company may go bankrupt, leaving you with a worthless share in a company that no longer exists.

Another example of a different type of risk can occur when buying a bond. Purchasing a bond is similar to lending money to the entity selling the bond. The bond seller agrees to pay interest to the bondholder for a specified period. If the bond seller does not have the funds necessary to pay the interest, you will lose the return on the money you lent.

Note: Bondholders are generally paid first if the company goes bankrupt.

Types of Risks

Investors should be aware of many types of risks. Each type has unique characteristics that affect how risk impacts your investments.

Business Risk

Business risk applies to stocks and bonds issued by companies. Companies always face the risk that may reduce their income or force them to close their doors. For example, rising raw material costs may mean that the company’s stock price declines because the company makes less profit and struggles to pay its debts.

Volatility Risk

Certain investments, such as stocks, can experience significant price volatility. Even large, stable companies can see their stock prices move up and down. If you can hold the investment for a long time until its price increases, volatility risk may not matter. However, if you encounter a situation where you need to sell quickly, and the volatility of the investment has caused its price to fall below the price you paid, you may have to sell at a loss.

Inflation Risk

Inflation is the process by which money loses value over time. Economists generally agree that small amounts of inflation are good for the economy, but sometimes inflation can rise to higher levels.

Liquidity Risk

Liquidity risk describes the chance that you may have difficulty finding someone to buy your investments if you need to sell them to use the cash for other purposes. There is no guarantee that someone will be willing to buy an investment that you wish to sell, and some securities, such as certificates of deposit, impose penalties for early withdrawal if you liquidate the investment before maturity.

Other Forms of Risks

There are many other forms of risk that investors need to be aware of. For instance, investing in a foreign country involves volatile currency values. Social and political risks can be a factor if you invest in a company that becomes a target for activists or operates in an unstable country experiencing war, famine, a pandemic, or another major event.

Note: It is important to conduct due diligence to identify potential risks and plan for them when formulating an investment strategy.

Do I Need to Take Risks?

Everything in life involves a certain level of risk, and this also applies in the investment world. Even one of the safest places to put your money, an FDIC-insured savings account, carries inflation risk and other types of risks.

And with…

Thus, the amount of risk you accept is up to you. Generally, risk and reward are linked. The greater the risk you accept when purchasing an investment, the higher the potential returns.

For example, bonds are typically considered a safer investment than stocks. To compensate for the higher risk, stocks offer higher returns. Over the past ten years, the Vanguard Total Stock Market Index Fund has provided a return of 14.20% compared to the 3.24% return of the Vanguard Total Bond Market Index Fund.

Some types of options and other derivatives may involve infinite risk. However, derivatives also have the potential to generate huge profits.

Every investor needs to determine the level of risk they are comfortable with and align it with their investment goals.

What Does Risk Mean for Individual Investors?

Individual investors must accept the existence of investment risk, even in investments that seem 100% safe. Therefore, it is important to implement the following two steps while establishing your investment strategy.

First, review your investment goals and the level of risk necessary to achieve them. Make sure you fully understand the level of risk you are accepting when making an investment decision.

Second, minimize risk wherever possible. One common way to reduce risk is to build a diversified investment portfolio. Holding many different securities can limit the impact of certain forms of risk on the overall performance of your investments, increasing your chances of making profits from your investments.

Takeaway

All forms of investment involve risk. Investors should consider many types of risk. Generally, risk and return are interconnected. The higher the risk you accept when buying an investment, the greater the potential returns. Diversification can help reduce investment risk. Individual investors should accept the existence of risk and minimize it wherever possible.

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Sources:

– Board of Governors of the Federal Reserve System. “Why Does the Federal Reserve Aim for Inflation of 2% Over the Longer Run?” Accessed June 21, 2021.

– Vanguard. “Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX).” Accessed June 21, 2021.

– Vanguard. “Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX).” Accessed June 21, 2021.

Source: https://www.thebalancemoney.com/what-is-risk-5189641