RISK IN INVESTMENT

What Is Risk?
Risk is defined in financial terms as the chance that an outcome or
investment’s actual gains will differ from an expected outcome or return.
Risk includes the possibility of losing some or all of an original
investment.
Quantifiably, risk is usually assessed by considering historical behaviors
and outcomes. In finance, standard deviation is a common metric
associated with risk. Standard deviation provides a measure of the
volatility of asset prices in comparison to their historical averages in a
given time frame.
Overall, it is possible and prudent to manage investing risks by
understanding the basics of risk and how it is measured. Learning the risks
that can apply to different scenarios and some of the ways to manage
them holistically will help all types of investors and business managers to
avoid unnecessary and costly losses.

The Basics of Risk

Everyone is exposed to some type of risk every day—whether it’s from
driving, walking down the street, investing, capital planning, or something
else. An investor’s personality, lifestyle, and age are some of the top
factors to consider for individual investment management and risk
purposes. Each investor has a unique risk profile that determines their
willingness and ability to withstand risk. In general, as investment risks
rise, investors expect higher returns to compensate for taking that risks.
A fundamental idea in finance is the relationship between risk and return.
The greater the amount of risk an investor is willing to take, the greater the
potential return. Risks can come in various ways and investors need to be
compensated for taking on additional risk. For example, a U.S. Treasury
bond is considered one of the safest investments and when compared to
a corporate bond, provides a lower rate of return. A corporation is much
more likely to go bankrupt than the U.S. government. Because the default
risk of investing in a corporate bond is higher, investors are offered a
higher rate of return.
Quantifiably, risk is usually assessed by considering historical behaviors
and outcomes. In finance, standard deviation is a common metric
associated with risk. Standard deviation provides a measure of the
volatility of a value in comparison to its historical average. A high standard
deviation indicates a lot of value volatility and therefore a high degree of
risk.
Individuals, financial advisors, and companies can all develop risk
management strategies to help manage risks associated with their
investments and business activities. Academically, there are several
theories, metrics, and strategies that have been identified to measure,
analyze, and manage risks. Some of these include: standard deviation,
beta, Value at Risk (VaR), and the Capital Asset Pricing Model (CAPM).
Measuring and quantifying risk often allows investors, traders, and
business managers to hedge some risks away by using various strategies
including diversification and derivative positions.
KEY TAKEAWAYS
 Risk takes on many forms but is broadly categorized as the chance
an outcome or investment’s actual gain will differ from the expected
outcome or return.
 Risk includes the possibility of losing some or all of an investment.
 There are several types of risk and several ways to quantify risk for
analytical assessments.
 Risk can be reduced using diversification and hedging strategies.

Riskless Securities

While it is true that no investment is fully free of all possible risks, certain
securities have so little practical risk that they are considered risk-free or
riskless.
Riskless securities often form a baseline for analyzing and measuring risk.
These types of investments offer an expected rate of return with very little
or no risk. Oftentimes, all types of investors will look to these securities for
preserving emergency savings or for holding assets that need to be
immediately accessible.
Examples of riskless investments and securities include certificates of
deposits (CDs), government money market accounts, and U.S. Treasury
bills. The 30-day U.S. Treasury bill is generally viewed as the baseline,
risk-free security for financial modelling. It is backed by the full faith and
credit of the U.S. government, and, given its relatively short maturity date,
has minimal interest rate exposure.

Risk and Time Horizons

Time horizon and liquidity of investments is often a key factor influencing
risk assessment and risk management. If an investor needs funds to be
immediately accessible, they are less likely to invest in high risk
investments or investments that cannot be immediately liquidated and
more likely to place their money in riskless securities.
Time horizons will also be an important factor for individual investment
portfolios. Younger investors with longer time horizons to retirement may
be willing to invest in higher risk investments with higher potential returns.
Older investors would have a different risk tolerance since they will need
funds to be more readily available.

Morningstar Risk Ratings
Morningstar is one of the premier objective agencies that affixes risk
ratings to mutual funds and exchange-traded funds (ETFs). An investor
can match a portfolio’s risk profile with their own appetite for risk.

Types of Financial Risk


Every saving and investment action involves different risks and returns. In
general, financial theory classifies investment risks affecting asset values
into two categories: systematic risk and unsystematic risk. Broadly
speaking, investors are exposed to both systematic and unsystematic
risks.
Systematic risks, also known as market risks, are risks that can affect an
entire economic market overall or a large percentage of the total market.
Market risk is the risk of losing investments due to factors, such as political
risk and macroeconomic risk that affect the performance of the overall
market. Market risk cannot be easily mitigated through portfolio
diversification. Other common types of systematic risk can include interest
rate risk, inflation risk, currency risk, liquidity risk, country risk, and sociopolitical risk.

Unsystematic risk, also known as specific risk or idiosyncratic risk, is a
category of risk that only affects an industry or a particular company.
Unsystematic risk is the risk of losing an investment due to company or
industry-specific hazard. Examples include a change in management, a
product recall, a regulatory change that could drive down company sales
and a new competitor in the marketplace with the potential to take away
market share from a company. Investors often use diversification to
manage unsystematic risk by investing in a variety of assets.
In addition to the broad systematic and unsystematic risks, there are
several specific types of risk, including:

Business Risk

Business risk refers to the basic viability of a business—the question of
whether a company will be able to make sufficient sales and generate
sufficient revenues to cover its operational expenses and turn a profit.
While financial risk is concerned with the costs of financing, business risk
is concerned with all the other expenses a business must cover to remain
operational and functioning. These expenses include salaries, production
costs, facility rent, office, and administrative expenses? The level of a
company’s business risk is influenced by factors such as the cost of
goods, profit margins, competition, and the overall level of demand for the
products or services that it sells.

Credit or Default Risk

Credit risk is the risk that a borrower will be unable to pay the contractual
interest or principal on its debt obligations. This type of risk is particularly
concerning to investors who hold bonds in their portfolios. Government
bonds, especially those issued by the federal government, have the least
amount of default risk and, as such, the lowest returns. Corporate bonds,
on the other hand, tend to have the highest amount of default risk, but also
higher interest rates. Bonds with a lower chance of default are
considered investment grade, while bonds with higher chances are
considered high yield or junk bonds. Investors can use bond rating
agencies—such as Standard and Poor’s, Fitch and Moody’s—to determine
which bonds are investment-grade and which are junk.

Country Risk

Country risk refers to the risk that a country won’t be able to honour its
financial commitments. When a country defaults on its obligations, it can
harm the performance of all other financial instruments in that country—as
well as other countries it has relations with. Country risk applies to stocks,
bonds, mutual funds, options, and futures that are issued within a
particular country. This type of risk is most often seen in emerging
markets or countries that have a severe deficit.

Foreign-Exchange Risk

When investing in foreign countries, it’s important to consider the fact that
currency exchange rates can change the price of the asset as
well. Foreign exchange risk (or exchange rate risk) applies to all financial
instruments that are in a currency other than your domestic currency. As
an example, if you live in the U.S. and invest in a Canadian stock in
Canadian dollars, even if the share value appreciates, you may lose
money if the Canadian dollar depreciates in relation to the U.S. dollar.

Interest Rate Risk
Interest rate risk is the risk that an investment’s value will change due to a
change in the absolute level of interest rates, the spread between two
rates, in the shape of the yield curve, or in any other interest rate
relationship. This type of risk affects the value of bonds more directly than
stocks and is a significant risk to all bondholders. As interest rates rise,
bond prices in the secondary market fall—and vice versa.

Political Risk

Political risk is the risk an investment’s returns could suffer because of
political instability or changes in a country. This type of risk can stem from
a change in government, legislative bodies, other foreign policy makers, or
military control. Also known as geopolitical risk, the risk becomes more of
a factor as an investment’s time horizon gets longer.

Counterparty Risk

Counterparty risk is the likelihood or probability that one of those involved
in a transaction might default on its contractual obligation. Counterparty
risk can exist in credit, investment, and trading transactions, especially for
those occurring in over-the-counter (OTC) markets. Financial investment
products such as stocks, options, bonds, and derivatives carry
counterparty risk.

Liquidity Risk
Liquidity risk is associated with an investor’s ability to transact their
investment for cash. typically, investors will require some premium for
illiquid assets which compensates them for holding securities over time
that cannot be easily liquidated.

Risk vs. Reward
The risk-return trade-off is the balance between the desire for the lowest
possible risk and the highest possible returns. In general, low levels of risk
are associated with low potential returns and high levels of risk are
associated with high potential returns. each investor must decide how
much risk they’re willing and able to accept for a desired return. This will
be based on factors such as age, income, investment goals, liquidity
needs, time horizon, and personality.
The following chart shows a visual representation of the risk/return tradeoff for investing, where a higher standard deviation means a higher level or
risk—as well as a higher potential return.
It’s important to keep in mind that higher risk doesn’t automatically equate
to higher returns. The risk-return tradeoff only indicates that higher risk
investments have the possibility of higher returns—but there are no
guarantees. On the lower-risk side of the spectrum is the risk-free rate of
return—the theoretical rate of return of an investment with zero risk. It
represents the interest you would expect from an absolutely risk-free
investment over a specific period of time. In theory, the risk-free rate of
return is the minimum return you would expect for any investment because
you wouldn’t accept additional risk unless the potential rate of return is
greater than the risk-free rate.

Risk and Diversification

The most basic—and effective—strategy for minimizing risk
is diversification. Diversification is based heavily on the concepts of
correlation and risk.11 A well-diversified portfolio will consist of different
types of securities from diverse industries that have varying degrees of risk
and correlation with each other’s returns.
While most investment professionals agree that diversification can’t
guarantee against a loss, it is the most important component to helping an
investor reach long-range financial goals, while minimizing risk.

There are several ways to plan for and ensure adequate diversification
including: