If you want to be an investor, you have to take risks. There’s no workaround to it – that’s just how things work in this line of “business” as risk takes on many shapes and sizes. I’ve briefly touched upon different types of investor risk in one of my previous writing exercises and the point is this:
learning the risks that can be highly relevant to various scenarios you’ll likely find yourself in is the first step to quantifying the level of impact of each type.
There are certain types of investors based on risk. Figuring out what type you’ll be (because we all follow certain templates) starts by understanding what you’re dealing with in order to be better positioned to avoid pitfalls and make sound financial decisions.
Types of investor risks
While every investment action comes with different risks and returns, investor risks are broadly divided into two main groups:
- Systematic – also known as market risks, these are any types of risk where the value of an investment is negatively impacted due to political and economic developments, as well as other market-affecting events.
- Unsystematic – also going by the names of nonsystematic, specific, idiosyncratic, diversifiable, and residual risks (way too many names), this is a group of risks that solely impacts a particular industry and/or company due to a specific hazard.
Systematic risks are intrinsic to an entire market or market segment, making them both extremely difficult to predict and completely stay away from. Common types can include:
- Equity risk – defined as the investment risk when the drop in the market price of the shares occurs, e.g. the drop of share price below its original purchase price.
- Interest rate risk – refers to the risk of change in the value of an asset as a result of volatility in interest rates, e.g. market value of the debt security may drop below its initial purchase price if the interest rates increase.
- Currency risk – the risk of losing money on foreign exchange investments due to changes in the exchange rates, e.g. the depreciation of a certain currency with respect to another.
- Inflation risk – the possibility that the cash flows from an investment won’t be worth as much in the future due to changes in purchasing power caused by inflation, e.g. a bond that generates a fixed rate of return has diminished return as the inflation reduces the purchasing power.
- Liquidity risk – relates to an investor’s (in)ability to transact investment for cash, e.g. failure to meet short-term financial demands due to losses of capital and/or income.
Because they imply all sorts of financial, economic, and geopolitical factors such as operating expenses, tax, demand and supply, interest and exchange rates, inflation, recession, wars, trade conflicts, overregulation, and other major and minor changes, systematic risks can’t be readily reduced through portfolio diversification.
For instance, a decline in asset value like housing or stocks due to the bursting of real estate (as is sometimes the case) or a rise in interest rates or simply politics can be the catalyst to bank crises, which could lead to systematic risk. However, systematic risks can be partially mitigated through asset allocation – dividing your investments among different asset categories with low correlation. Different asset classes react differently to external factors so when one is increasing (e.g. international stock, cash), others may be decreasing and vice versa.
As the other half of two main components of investment risk, unsystematic risks are in contrast with systematic risks as they can be mitigated through portfolio diversification because they are unique to a specific company or industry. Maintaining a variety of stocks across different industries and other types of securities in multiple asset classes smooths portfolio volatility. In essence, investors will be less affected by the developments of a single event.
For example, if you had stock in an airline or hotel during the COVID-19 pandemic, you’d face an extremely high level of unsystematic risk or more precisely – be royally screwed.
The danger corresponding with investing in only one asset that might go up or down is generated by internal and external elements such as the operational efficiency of the business, the capital structure of a company, new industry regulation, and even a shift in user behavior.
Generally speaking, investors are exposed to both systematic and unsystematic risks but these represent only a broader categorization. There are other, more specific types of investor risk such as:
- Business risk – the basic viability of a business and its vulnerability to various factors such as competitors, customer preferences, demand level, and everything else that might have an effect if the business in question will be able to generate enough revenue to cover its operational expenses and turn a profit. Business risk has its own subset of specific, business-related risks such as strategic, operational, reputational, and compliance.
- Volatility risk – the risk of the value drop of an investment due to the volatility (price swings) of the underlying asset like stock. Volatility risk is directly tied to the width of the trading range between the high and low price levels at which a stock or commodity has traded.
Risk takes on many forms
Learning as many types of investor risks as possible that can influence different scenarios, as well as ways to manage them holistically will help all types of investors (especially the aspiring ones) to steer clear of unnecessary and expensive losses. When figuring out how to minimize or avoid altogether the probability of losing some or all of an investment or business venture, two things are key:
- Get to know the types of risk tolerance and identify yours;
- Deploy the right risk management plan.
Do note that the specific factors and circumstances that will affect your risk tolerance may be less important than your abilities as an investor to make a calculated risk. Once you understand what to expect and how to approach risk, you’ll be able to find consistency in selecting investments that perform as expected or even outperform.
Naturally, the unpredictable nature of markets will make this ordeal a difficult one. Remember that when targeting low- and medium-risk investments for high returns, maintain a diversified portfolio and always keep in mind that high returns usually concur with higher risk investments. Whether you make them is up to you.