Luisa Rollenhagen is a journalist and investor who writes about financial planning for Wealthsimple. She is a past winner of the David James Burrell Prize for journalistic achievement and her work has been published in GQ Magazine and BuzzFeed. Luisa earned her M.A. in Journalism at New York University and is now based in Berlin, Germany.
There’s no such thing as a risk-free investment. Some investments can be considered “safer” than others, but there’s always a certain level of risk associated with investing. But what do we actually mean when we talk about “investment risk”?
What is investment risk
Let’s say you’ve just received your undergraduate degree, and you’re debating whether you should continue with your education and get your masters degree. Many people in your chosen field often go on to get higher degrees before going into the job market. And while a lot of advice you’re hearing, including from your academic advisor, your parents, your fellow students, and people out in the field, is that a Masters degree can help you get a competitive edge on other applicants, give you more skills, and expand your professional network.
Wealthsimple offers an automated way to grow your money like the world's most sophisticated investors. Get started and we'll build you a personalized investment portfolio in a matter of minutes.But there’s no guarantee that any of this will actually help you land a better job, or any job at all, once you finish that degree. And you also have to consider that the time spent on completing your degree could have potentially been used on getting a job and gaining practical experience and connections that might give you an advantage further down the line.
There’s also a real financial cost associated with getting a masters degree: You might need to take out student loans to finance your studies, and even if you’re able to afford the degree through scholarships and personal funds, you’re still missing out on the potential income you could have earned if you had been working full-time instead of studying. This is also known as an opportunity cost.
So while going back to university is often considered an “investment” in your future, it also comes with significant risks attached. At the end of the day, you simply can’t predict the outcome to a precise degree. There will always be a level of uncertainty associated with going to graduate school, and some of the potential outcomes could be less than beneficial for you. And yet: The potential benefits of getting your masters degree may outweigh the negatives as you try to break into the a competitive job market. When we consider risks, we’re always evaluating and balancing the relationship between risk—what we might lose—and reward—what we might gain.
The “high risk/high reward” relationship
It’s exactly the same when it comes to finance, and specifically when it comes to investing. When you choose to invest in something, you’re spending money toward the goal of getting more money back than you initially put in. But there’s also the risk of losing the money you’ve put in. In many ways, risk is simply a measure of how much your investments will fluctuate depending on how markets move.
Usually, the more risk you take on, the greater the potential for higher rewards is. The key word here is potential: There isn’t a purely linear relationship between higher risk and higher returns. The risk of your investment is the price you pay for the possibility, not the certainty, of higher rewards. Since companies, corporations, industries, and governments need money in the form of investments, the potential for high rewards for investors is higher when investors are willing to put more on the line. If you take on lower levels of risk, your investments will gain less or lose less if markets rise or fall, respectively. Taking lower risks generally leads to less volatility, or more stability. You know the line: No risk, no reward.
But no risk will ever be the same, and the level of risk is always unique to each individual person. Your personality, your lifestyle, your age, and your financial situation are all factors that will likely shape your individual ability and willingness to take on risk.
Standard deviation and other risk measurements
But how do you even begin to evaluate risk, or volatility? A popular method to break down investment risk is to calculate the standard deviation of an asset’s past prices. If your last statistics class was a couple of years away, a standard deviation helps identify any variation from an average. So an asset’s high standard deviation indicates that it’s a more volatile asset, which means that it’s associated with more risk. Other popular risk measurements include alpha and beta ratios and the capital asset pricing model. However, keep in mind that these are all indicators: There’s no one-size-fits-all method to determine how risky an investment is.
What are investment risk factors
We’ve covered that risk is a unique and individual state that highly depends on several personal factors. But if we put that aside for a moment, there are several factors inherent in an asset that can help you determine how risky an investment might be. Here are some investment risk factors worth keeping in mind when trying to evaluate whether to invest in a particular investment.
Market risk. If something within the market happens that causes an economic downturn, a change in interest rates, or instability, then there’s a high risk that your investments will decline in value and you will lose money. In that case, investing in a volatile market would increase your exposure to risk.
Business risk. This is similar to market risk, except instead of referring to the market it is tied to the business in which you’re investing—particularly if you’re investing in stocks. Bad earnings reports, bad leadership or leadership misconduct, or bad products can all increase risk and drop the value of your investments.
Concentration risk. Diversity is the cornerstone of any smart investment strategy, which is probably why we like to talk about it so much. When you diversify your investments and ensure that you’re spreading your money out across various different industries and types of assets, you’re lowering your risk. That’s because betting everything on one card, i.e. one stock, is highly risky: If that company’s value tanks or even just takes a dip, then you’ll suffer a much greater loss than if you had placed your eggs in many baskets to offset any potential losses. So concentrating on one company or one area usually implies a higher investment risk.
Inflation risk.