This page of our SIE Study Guide focuses on the various types of investment risks along with the strategies for mitigating these risks.
Types of Investment Risks
Every investment carries a certain level of risk. We tend to think of this risk as the potential—or unexpected—financial loss associated with our investment decision and the possibility that we might lose some or all of our initial investment. The list below is non-exhaustive and contains some examples of common investment risks.
Market Risk — Systematic Risk: Risk that applies to a market or market segment as a whole. A stock market ‘crash’, for example, will tend to drive down the market price of nearly all stocks, even the best ones.
Business Risk — Non-Systematic Risk: Risk that applies to a specific company or line of business. If you’ve only invested in one company and that company experiences a downturn (or bankruptcy), you could suffer a substantial loss. Putting all your eggs in one basket is not a wise investment strategy.
Inflationary/Purchasing Power Risk: Risk that an increase in inflation will lead to a reduction in the purchasing power of your investment returns. Fixed income investments lose purchasing power each year due to inflation eating away at the value of the dollar. By comparison, investments whose cashflows tend to increase when general price levels increase, such as investments in commodities or real estate, may mitigate the effect of inflation, despite their other risks. Inflation also tends to exert upward pressure on equity prices, all other things being equal.
Interest Rate/Reinvestment Risk: Risk that the cash flows received from an investment won’t generate the same returns when reinvested. Fixed income investments, which generally make coupon or interest payments, are particularly susceptible to this risk. Reinvestment risk increases in environments where interest rates are declining.
Credit Risk: Risk that a borrower will fail make payments on a loan. AAA-rated bonds are considered the least risky because their issuers have demonstrated a history of meeting their financial commitments. The lower the credit rating, the higher the credit risk. Funds that hold debt instruments are also vulnerable to credit risk.
Foreign Currency Risk: Risk of losses resulting from fluctuations in foreign currencies. Any investor who purchases investments in non-U.S. corporations where dividends are declared and paid in foreign currency (think British Pounds, Japanese Yen, European Euros, etc.) is exposed to this risk.
Liquidity Risk: Risk that an investment can’t be bought or sold quickly enough to counter or lessen a loss. Liquid investments are readily sellable at fair market prices. Illiquid investments on the other hand are difficult to sell, and the prices received may be subject to high volatility.
Prepayment Risk: Risk that the principal amount of a debt investment is paid back prematurely (leading to fewer interest payments down the line). For example, there are investments in the debt space known as mortgage-backed securities (MBS). These are packaged products whose portfolios are comprised of mortgages that provides interest income to investors. The property owner (1) selling the property or (2) refinancing the mortgage when interest rates go down would both be prepayment risk scenarios.
Political Risk: Risk that an investment’s returns would decline due to political changes (or uncertainty) in a foreign country. In some cases political risk can also lead to the confiscation of investment capital.
Strategies for Risk Mitigation
Investment risk is unavoidable. However, there are several different ways for investors to reduce—or mitigate—their overall risk. Below are some strategies to consider.
Diversification: Don’t put all your eggs in one basket. There is less risk if you spread your money across a variety of investment products and industries as these will all react differently to certain economic events.
Alternative (Non-Securities) Investments: One can put money into investments that are not debt or equity securities. These might include artwork, coins, collectibles, certificates of deposit, fixed annuities, or real property.
Hedging: There are investments that can provide some protection against the market moving in the wrong direction. These hedging strategies typically include some sort of derivative product like an option or future contract. At its basic level, a hedge instrument will tend to appreciate in value while the portfolio loses value. The goal is to offset any portfolio loss with the profit on the hedge.
Portfolio Rebalancing: An investment portfolio is generally comprised of a specific asset allocation that is based on the investor’s level of risk. When one asset class or stock appreciates in value this asset allocation can become unbalanced, exposing the investor to potential risk and volatility. The investor can rebalance their portfolio by selling and buying certain investments to restore the original target asset allocation. It is common for investors to rebalance their portfolios on a fixed schedule, such as annually.
Sector Rotation: Getting your money out of one business sector—think energy, health care, transportation, financial services, etc.—and into another is referred to as sector rotation. The intent behind this strategy is to follow the economy as it moves through the different phases of the business cycle thereby only putting your money into industries that perform well during certain phases.