Risk is the possibility of loss. Sometimes the loss is trivial, while at other times it may cause major personal and financial hardship. No investment is completely risk-free, but some investments carry more risk than others.
All investments carry with them some degree of risk, and may arise from many sources. Stocks, bonds, mutual funds and exchange-traded funds can lose value, even all their value, if market conditions sour. Even conservative, insured investments, such as certificates of deposit issued by a bank or credit union, come with inflation risk. And some investments carry more risk than others – generally, the higher the expected return, the greater the risk.
By better understanding the nature of risk, and taking steps to manage those risks, you put yourself in a better position to meet your financial goals.
Classification of risk
What is risk? Risk is the danger that unwanted events may happen or that developments go in an unintended direction. Investment risk is the possibility that you might lose some or all your original investment, or that the investment may not perform as expected. Generally, the higher the chance of a loss occurring, the higher the investment risk and the higher the expected returns should be.
When you invest, you are exposed to different types of risk. These key risks include:
Outside of these core financial risks are a plethora of other risks such as country risk, systemic risk, behavioural risk and governance risk for instance. These risks however are more aligned with big-business and corporate strategy.
Why have any risk in your portfolio?
We define investments in two broad categories: growth assets and defensive assets. Growth assets are usually shares or property. These investments generally have the potential to earn higher returns but carry higher risk over the short term. The rate of return of the investment may vary and the value of the investment may be more volatile.
Defensive assets on the other hand, provide little chance of capital loss but generally earn a lower return. These types of assets include cash and fixed interest, and returns are less likely to fluctuate in the short term.
When you invest, you expect to get a return on your money. You're probably also hoping you'll be able to buy more with your money in the future than you can today. If so, your return needs to be higher than the rate of inflation. As such, the amount of risk and the kind of assets you invest in, can affect your investment outcomes:
You cannot eliminate investment risk completely, but creating a risk management strategy can help to reduce your risk.
Managing risk
Every investor should have a risk management framework aligned to their investment objectives and time horizon. Risk management is important because it can reduce or augment risk depending on your goals. It is a two-step process of determining what risks exist in an investment and then handling those risks in a way best-suited to your investments.
Developing an effective framework requires measuring, monitoring and managing exposures to both economic and fundamental drivers of risk and return across asset classes to avoid overexposures to any one risk factor. Your risk management framework should also enable dealing with risk during both normal times and extreme events. Your financial adviser can help you to set-up an effective risk management strategy.
There are many things you can and should do to manage the risks associated with investments. These include, but of course, are not limited to:
There are also two basic investment strategies which can help manage your risk
Hedging (buying a security to offset a potential loss on another investment) can also provide an additional way to manage risk. However, hedging typically involves speculative, higher risk activity such as short selling (buying or selling securities you do not own) or investing in illiquid securities.
Your financial adviser can help you to create a portfolio which reflects both your short-term needs and longer-term financial goals. They will also work with you to determine your attitude to risk, and will consider issues such as investment time horizon and wealth level to establish your risk tolerance.
Disclaimer: The information contained in this communication is general in nature and does not take into account your objectives, financial situation or needs. You should consider whether it is appropriate for your personal circumstances prior to making any investment decision.