Investments of any kind that hope to provide a positive return will carry some form of investment risks. As a rule of thumb, higher risk typically means higher expected return. Otherwise, what is the point of investing and taking on risk in the first place?
This post doesn’t intend to discourage you from investing, but it does explain various types of risks. Investors must understand how smart asset choices and diversification can mitigate most but not all of these risks.
Public vs. Private Markets
Before we get into details on the types of risks involved, let’s take a look at public vs. private markets. Gordon Gecko vs. KKR or Mr. Warren Buffet vs. Venture. Our guide only deals with public market investments, so it is essential to distinguish the two. Private and public markets will also carry fundamentally different type of investment risks.
Public markets commonly refer to stocks, bonds, mutual funds, Exchange Traded Funds (ETFs), and all the derivative products like Options, Futures, and so on. In public markets, shares of the companies are available to the common public for buying and selling. Stocks and bonds are traditional asset classes and are most common. Public markets are open for everybody to invest in. It is straightforward for anybody to get started. Open a brokerage account, check out our guide at mguide.co/investment-guide/ and off you go.
Private markets are typically known for the fast-growing companies that are not available to the general public. Private markets include venture capital firms investing in startups and private equity firms investing in well-established companies.
The general public cannot invest in private markets as more immense capital is required for investment. Private investments are generally a lot riskier. That makes sense since a lot of these companies are small, private without any supervision. Private companies are not well regulated as these are not answerable to public shareholders. Moreover, they are not liable to publicly disclose their financial reports or submit them for auditing, thus making them less reliable.
So, unless you are an accredited investor who has some money tied with venture funds or has access to entrepreneurs looking for capital, private investments are not a sustainable solution. Not to worry, public markets offer incredible investment opportunities that are safer and arguably can produce similar or even better returns.
But any investment is not without risk. Let’s discuss some of the potential and most common risks involved. Finance professors like to use some ambiguous words, and we will try to translate that into what different risk means for us as day-to-day investors.
Types of Risk
In this type of risk, the value of investments declines due to market collapse or some economic developments that impact the entire market. Okay, this is just like saying it’s risky participating in the stock market because the stock market itself is risky. If the whole market declines, well your investments will likely fall as well. This is one of the investment risks that is impossible to avoid.
There can be other types of market risks like interest rate risk, currency risk, and equity risk.
Interest rate risk
Just like the name infers, it is a risk of your investments going down in value when interest rates change. Primarily interest rate changes impact bond investments. When you purchase a bond that earns 3%, for example, and then suddenly, interest rates go up in the market, the 3% that you make is not as good as it once was. The bond you hold is not paying you more than 3%. If you want to sell it, the buyer will pay you less for it.
This is the risk of buying investments in another currency. When you purchase such an investment, you have to convert to the currency of that investment. The most common of the investment risks for foreign investors. When people buy U.S stocks outside of the U.S. To do that, you have to buy US dollars first then purchase your investment. When USD goes up in value relative to your home currency, your investment goes up in value and vice-versa.
Refers to the risk of holding stocks of a company. When you buy stocks, you purchase a small % of that company or “equity.” When the value of that company goes down, or the company stock price goes down, the value of your holdings goes down as wel
Liquidity is a fancy word that means how quickly an investor can sell the investment and get cash. The most liquid asset is cash itself because you don’t have to sell it to get money. It is already money. Stocks are reasonably liquid if the demand is there. During market hours, you can sell a stock with a few clicks. Real estate is an example of a not-so-liquid asset. If you need money quickly, you can’t sell your property with a few clicks. The process of selling is more convoluted.
Other types of investment risks to consider
Prices tend to go up, called inflation. Inflation reduces our purchasing power, and our money loses value every single day. If you hold cash, the risk is that it will lose value. Another risk to consider is how inflation impacts fixed-income investments. It has to do with how central banks respond to inflation. If inflation is higher than expected, central banks respond by raising interest rates. When interest rates rise in the market, individual bond holdings go down in value because their interest rates are fixed.
This risk is associated with ups and downs in any country’s economy due to unforeseen events or circumstances.
Common risk among new investors as they invest all of their money in one type of investment. Concentration risk is easy to manage with intelligent diversification.
The risk applies to debt investments like bonds. If the organization that issued the bond runs into financial trouble, we might not be getting paid. This risk is low for well-established companies and governments but is still present.
Risk of Being Extra Cautious
When people ask Warren Buffet about investment mistakes, his answer is always about investments that he didn’t make, not investments that lost him money. When we have enough research & expertise about certain assets but not go ahead with them because of unfound fear, that hurts the most in the long run.
Final thoughts. Diversifiable vs. Nondiversifiable risk.
Some risks, like credit risk or interest rate risk, can be managed by diversification. Don’t just purchase bond ETFs, have stock ETFs in your portfolio as well to mitigate some of the risks, and so on.
Other risks like market risk cannot be diversified away and will always be present. We have no other choice but to accept these risks and live with them. When these risks present themselves in actual events that are typically unforeseen, it can be excruciating. But we must remember that there is nothing we could have done to mitigate them.