Most investments don’t have a guaranteed rate of return. All investments involve some degree of risk, some are considered riskier and others safer investments. The value of investments is influenced by many factors, such as economic and market conditions, government policy, interest rates, currency movements or inflation.
Why would anyone invest?
Over the longer term, the returns on investments are significantly higher than the rate of interest on cash. Investments made today are meant to pay rewards in the future. Investors also try to protect themselves against different types of risk when buying securities. At the moment we are living in a world where inflation is higher than what is considered “average” or “normal”. That means keeping money in your bank account is actually not a very good idea.
In order to build your wealth successfully, it’s important to have a certain strategy and familiarise yourself with potential risks. Each specific investment approach and product will have its own specific risks and those risks will vary. These are some types of risks. This is not an all-inclusive list.
- Systemic risks are coming from the biggest companies in the world and if something happens with them then the ripple effect could affect almost all of the economy. For example, the 2008 global financial crisis resulted in almost all types of investment falling in value when the companies considered “too big to fail” started to fail. Governments use systemic risk as an excuse to intervene with the economy and limit the ripple effect when and if needed. In 2008 without the bailout of AIG, the ripple effect would have caused the collapse of many other financial institutions.
- Non-systematic risks apply for risks that are specific for a certain company or sector. These risks can be reduced by investing in different sectors. An example of a non-systematic risk is a new provider in the market or a change in the regulatory framework.
- Liquidity risks are the risks to a firm’s ability to pay back its debt. It’s always a good idea to check company’s cash flow and outstanding debts. Make sure they are generating enough cash to pay for all the bills or are planning to reach that point in sometime near future. When a company reaches a point where they don’t have enough available funds to cover short-term debts they are experiencing liquidity risk
- Exchange rate risks are type of risks that come with overseas investments and foreign currencies. These risks are considerably higher when investing in emerging markets and are not fully avoidable. It is possible to mitigate these risks using currency futures or other similar financial products.
- Inflation risks mean that over time money is losing its value. Inflation is a decrease in purchasing power – to make it clear 100 USD buys you less today compared to 3 years ago. For investors, fixed bonds are considered to be especially susceptible to this risk.
- Interest rate risk is the possibility to decrease the value of your fixed-income investment if the overall interest rates go up. Interest rates affect many other investments but bonds are in the biggest risk. Often fixed-income investments offer a higher return to lower this risk.
- Credit risks cover the risk that comes with the ability of the issuer to repay the funds or interest rate. This mostly applies for investments that promise some form of guaranteed payments. These kinds of securities are usually rated by credit agencies and the lower the grade, the higher the credit risk.
- Social, political and legislative risks are types of risks that follow human behaviour or decision-making. For example, there could be a change in regulations for banks or a trading embargo with certain countries and their economy would suffer. Lately, the world is preparing to move towards green energy and this is a major change in the social sense that affects many sectors.
Risk and diversification
The most basic and effective strategy to minimise risk is diversification. Diversification means that you should not invest all of your funds into one certain investment but spread it around over multiple different investments. If one investment goes bad then you have risked all of your funds on one deal. But if you spread your funds on multiple different investments then you are better protected and might find the next big winner more easily. One of the most well-known comparisons is that it’s smart to invest in sunglasses and umbrellas. When it’s raining you’ll make money on umbrellas and when the weather changes and the sun comes out, then people will need sunglasses. This is the simplest example of diversification.
Diversification also means you should look toward different sectors. Let’s say for example that I invest all of my money into airlines. It does not matter what airline stocks I’m buying but if travelling is hindered by corona for example then all of the airlines will be losing their value. But if I try to diversify my portfolio and add energy and gaming investments for example then these 2 sectors are not that intertwined with airlines and won’t be in danger of the same risks. I have protected my investments and am not fully dependent on only tourism.
Diversification doesn’t ensure gains or guarantee against losses, it does provide the potential to improve returns based on your goals and target level of risk. There are always risks when making investments but it is possible to minimise most of the risks when you have the full picture of potential issues