Investment Risk – How to Use It to Your Advantage

An infographic that explains investment risk: its characteristics, risk-return trade off, how to manage it, and what factors influence your risk tolerance

Regardless of the type of investment, there is always some risk involved. For example, in finance, investment risk is the probability that the outcome will not be as expected. Therefore, investors must compare the potential returns against the risk before deciding which investments to put their hard-earned money in.

Whether it is a risk of inflation or volatility of a stock, investment risk is a significant factor you should consider when entering the market. Moreover, at a time of unpredictable interest rates and trade wars, risk has become a more critical factor to consider than ever before. 

Let us try to understand what investment risk is, the different types of investment risk, how risk is related to reward, and how it is measured and managed.

What Is Investment Risk?

Investment risk is the uncertainty an investor accepts about the future returns expected from an investment. Risk also means the possibility of losing a part of the investment or even the whole investment.

Each type of investment including bonds, stocks, real estate, and mutual funds have their unique risk profile. In addition, investors also have their individual risk tolerance depending on their lifestyle, age, personality, and other factors. Understanding the differences between these investment risks will help investors manage them effectively.

Risk Versus Reward

Investment risk is related to reward. Generally, a higher risk has the potential for a higher return. The higher the level of risk an investor takes, the bigger the potential reward is. The trade-off is to achieve a balance between the lowest possible risk and the highest potential reward.

Generally, lower risk levels are associated with lower potential rewards, while a higher degree of risk brings higher returns. Therefore, investors should determine the amount of investment risk they are willing to take to reach their financial goals. This depends on several factors, including income, age, personality, time frame, investment goals, and liquidity requirements.

Below is a pyramid depicting the risk/return trade-off for various asset classes, where the potential return increases with increasing risk.

It is, however, worth noting that higher risk doesn’t automatically translate to higher reward. This trade-off only indicates the possibility of a higher return. The result is not guaranteed. The bottom of the pyramid depicts a risk-free rate of return, which is a return with no risk.

Risk-free Rate of Return is a theoretical concept that depicts a rate of return for investments with virtually no risk. It is the interest rate an investor expects from a zero-risk investment over a specific time period. However, this rate does not exist in practice because any investment has at least a small risk associated with it.

An infographic shows a risk triangle that shows the level of investment risk for different asset types.

Types of Investment Risk

There are 2 broad categories of investment risk: Systematic risk and unsystematic risk. Investors are exposed to both these types of risks.

Systematic Risk – This refers to market risks and can affect the whole economic market or a large percentage of it.

Systematic risk is the risk of losing money due to factors that affect the market performance, such as macroeconomic and political risks. Some other types of systematic risks include currency risk, inflation risk, liquidity risk, and interest rate risk.

Unsystematic Risk – Unsystematic risk or specific risk refers to the type of risk that affects a particular company or industry.

It is the risk of loss due to industry or company-specific hazards like a product recall, change in management, a new competitor, or a regulatory change. Such risks are often managed through diversification.

Investing involves many different risks. Here is an explanation of some of the primary types of investment risk.

Infographic that defines the 6 most common types of investment risk: business risk, interest rate risk, socio-political risk, credit risk, currency risk, and liquidity risk.

Market Risk

Market risk is a broad umbrella of investment risks and refers to losing investment value from economic events affecting the market. The three main market risks are:

Interest Rate Risk – This risk is most prevalent in debt securities and bonds. As the interest rate is closely related to bonds, the price of bonds falls when interest rates rise. However, interest rate risk also affects other fixed-interest vehicles such as savings accounts, money market accounts, and treasury bills.

Equity Risk – This type of risk pertains to stock investments. Stocks are quite volatile, and their prices keep fluctuating. Equity risk is the sudden drop in the market price of stocks, resulting in a loss.

Currency Risk – This risk applies to investments in foreign exchange. As a result, the value of your investment has a risk of declining in value due to exchange rate fluctuations.

Business Risk

This risk concerns the primary viability of a business. This refers to whether the business generates sufficient sales and revenue to cover its operational expenses and make a profit. This risk is anything that threatens a company’s ability to achieve its financial goals. It is affected by factors like competition, cost of goods, product demand, profit margins, etc.

Inflation Risk

Inflation risk is the risk that the future value of an investment or asset will be reduced by inflation, affecting its purchasing power. This risk examines how inflation reduces returns as the value of the investment erodes. Such risks are more concerning to investors who heavily invest in bonds.

Volatility Risk

Volatility risk refers to the investment risk that a portfolio’s value may fluctuate due to price swings in the market value of the underlying assets. This type of risk is generally seen in options trading, as options are of a highly volatile nature.

Country Risk

It is the risk that a country may not be able to fulfill its financial obligations. When a country defaults, it affects the performance of other financial instruments and other countries.

Country risk concerns mutual funds, stocks, bonds, options, and futures issued within the country. Such risks result from political changes or an economic slowdown in the country.

Credit Risk

Credit risk is a probability that the borrower may not be capable of paying back the interest or debt obligations. Such risk particularly concerns investors holding bonds in the portfolio.

Government bonds generally have the least credit risk and the lowest returns, while corporate bonds tend to have the highest credit risk and higher interest rates.

Socio-Political Risk

This type of risk refers to the investment risk associated with political or social factors like changes in government, policies, or legislative bodies. These risks are higher for long-term investments than short-term investments. 

How To Measure Investment Risk?

There are five primary tools investors use to measure risks. Each of these has a unique focus on investment risks. They are:

An infographic that explains 5 different ways to measure investment risk: Alpha, Beta, standard deviation, Sharpe ratio, and R squared.

Alpha

Alpha is a measure of performance. It refers to the excess return of an investment relative to the return of a suitable benchmark index like the S&P 500. A positive Alpha value means that an investment beats the market. An alpha of +1 means the security has outperformed its benchmark index by 1 percent. A negative Alpha indicates that the investment’s performance was below that of the market.

Beta

The Beta coefficient of a stock or fund is an effective way to measure risk quickly. This metric measures the volatility of a stock compared to the overall market. The S&P 500 is the most popular index for overall market comparison. 

The Capital Asset Pricing Model (CAPM) shows a relationship between the Beta and the expected return for an asset. The CAPM approach calculates the cost of equity based on this relationship to price stocks and securities and get expected returns.

A stock that has a beta of 1 has the same volatility as the overall market. If this value falls under 1, it is less volatile and risky. The utility sector generally has betas less than 1 as they tend to move slower than the market.

If the beta coefficient value is higher than 1, it means the stock has higher volatility than the market. For example, a stock with a beta of 1.3 means the stock is 30 percent more volatile and risky than the market. Generally, technology stocks are more volatile and, therefore, have betas with higher values.

Alpha and Beta are generally used in a combination to determine whether a stock is a good investment. For example, if a stock’s beta is 1.5 and the S&P 500 index goes up by 20%, you can expect a return of (20 x 1.5) 30%. But if the return is only 25%, the alpha is -5, which means you did not get enough reward for the extra risk.

Standard Deviation

One of the most commonly used risk measurement metrics, standard deviation, measures asset price volatility compared to the historical average over a period. A higher standard deviation means the stock is volatile, while the deviation of a stable stock is generally low.

Sharpe Ratio

The Sharpe Ratio estimates the return earned over a risk-free rate compared to the risk. It is simply the ratio of excess stock performance over a risk-free rate of return and the standard deviation of the investment.

R-Squared

This is a statistical risk measure that uses regressions to explain the movement of a variable compared to another dependent variable. R-squared is generally expressed as a percentage of the fund’s performance explained by a benchmark index.

How to Manage Investment Risk?

While there are many types of investment risks, there are various ways to manage this risk depending on the investor’s investment strategy.

Portfolio Diversification – Diversification is the most effective strategy for investment risk management. It involves creating a portfolio with various asset classes and investment vehicles, including bonds, certificates of deposit, stocks, ETFs, mutual funds, and others. Investing in any one stock or industry can be risky, while investing across an entire market reduces that risk.

Asset Allocation – An age-based asset allocation often helps manage investment risk. Younger investors can take more risk as they have a longer period of time to recover from their losses than older investors. So, younger investors should allocate more to stocks. Then, as they get closer to retirement, they should shift money from stocks to safer assets like bonds.

Dollar-Cost-Averaging – This technique refers to consistent investing. This means investing small amounts at regular intervals, regardless of asset prices. This strategy aims to reduce the impact of stock market downturns and volatility on the overall investment.

Margin of Safety – Value investors generally implement a margin of safety by deciding that they will purchase a stock when its market price is significantly lower than what they believe to be its intrinsic value.

The bigger the margin of safety, the higher is the potential for returns and the lower the risk. As risk is a subjective matter, every investor has a different margin of safety.

Hedging – Hedging is another effective way to mitigate investment risks. A hedge generally involves taking an offsetting position in another security. The best technique is through derivatives like options, futures, swaps, and forward contracts that move in correspondence to underlying assets such as stocks, commodities, bonds, and interest rates.

Assess Your Risk Tolerance

Your tolerance to investment risk depends on several factors, including your investment goals and experience, your time horizon, the size of your capital, and your psychological profile. Always remember, all investments carry some degree of risk. Here are a few principles you should follow when assessing your risk tolerance.

  • Expected investment returns are directly proportionate to the level of risk you are willing to take. The higher your profit expectations, the greater the risk.
  • Your goals and investment horizon. The longer your investment horizon, the more risk you can take.
  • The amount of capital you have. Typically, the more money you can invest, the more risk you can take.
  • Your experience as an investor. Typically, the more experience you have, the higher your risk tolerance.
  • Your psychological profile. You should only take as much risk as you are emotionally comfortable with.

In general, the investment risks you take should not keep you up at night. While some investors don’t feel comfortable when the unexpected happens, others might see investing as a game. The key is to avoid putting yourself in a situation that you cannot manage.

Conclusion

When you are an investor, you are always exposed to risk, regardless of what investment vehicle you choose. While there is no way to avoid risk completely, a good understanding of investment risks and individual risk profiles can help create an effective risk management strategy.

Investors should take a long-term approach when trying to manage risks. However, the risk management strategy also depends on the goals and age of the investor, so it is important to assess risk periodically and revise portfolios and strategies accordingly.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.