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Investment Risk Explained

Luisa Rollenhagen

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.

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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.

FS: The risk of your investment is the price you pay for the possibility, not the certainty, of higher rewards.

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. One of the main reasons why we advise against keeping large amounts of funds in cash or in savings is that it can easily be eaten up by inflation as time goes by. Let’s say the average annual inflation rate is 1.5%. If your money isn’t growing at or above that rate, the value of your funds will eventually depreciate. And while index markets like the S&P 500 tend to have an average annual growth rate of about 7%, that doesn’t mean that you’re totally risk-free. Depending on what kind of investments you’ve decided to put your money in and how high inflation is, you could run the risk of devaluation.

  • Foreign investment risk. Investing in foreign markets, especially if you’re investing in commodities like oil or in currency exchanges, always carries with it a certain level of risk because those assets are vulnerable to political or economic instability in their corresponding geographical region. So if you’re investing in foreign oil companies in a country that suddenly decides to nationalize its oil, then your investment is at risk.

Should I be investing money?

So now you might be asking: “If this investing thing is so risky, should I even be doing it at all?” We can’t really answer that question for you; at the end of the day, it’s your money, and you have to decide what to do with it. But imagine this: Most financial experts suggest that your retirement income should correspond to about 80% of your final pre-retirement salary. Even if you were a super-saver, it’s highly unlikely that you’ll be able to amass that quantity from savings alone. And if you factor in inflation risk, that goal starts getting even more unattainable.

The truth of the matter is that investing offers you much greater opportunities to grow your money and beat inflation than a run-of-the-mill savings accounts does. After all, savings accounts usually offer about 1% interest rates at most, whereas historically, markets have seen a growth of 5-7%. Another advantage of investing is that if you start early—there’s no time like the present!—then you have time to weather out any dips and depressions in the market, and perhaps even take on a bit more risk in order for your money to grow. That’s why time is considered to be one of the greatest factors in reducing risk: The more time you have to hold on to your investments, the more risk you can take on.

Investments and their degree of risk

One of the ways in which risk is controlled is through diversification. You can diversify your investments through asset allocation, which refers to how much of your money is in stocks (i.e. equities) versus how much is in bonds (i.e. fixed income). Here are how the most popular investments rank in terms of risk, but don’t forget: There is no guarantee that one investment is “safer” than the other. Investing will always carry with it a certain level of risk, no matter which asset you choose.

  • Cash. Usually, cash investments are at the bottom of the pyramid when it comes to the risk/reward relationship. This usually includes putting money in checking accounts and savings accounts And while saving will never produce the kind of growth you’re likely to see when you invest your money, a high-interest savings account—which offers higher interest rates than your traditional savings account, usually around 1-2%—may be an appealing alternative to you if you’re just starting out in your financial life and want to build a nice cushion before moving on to riskier but potentially more lucrative products.

  • Bonds. Bonds are usually considered to be one of the “safest” investments because their risk profile is quite low when compared to other types of assets. Unlike a stock, which makes no guarantees about fixed payments to its investors, a borrower, otherwise known as a bond issuer, sets out these terms to the lender, or bondholder. There are different kinds of bonds, and some will be less volatile than others, and come with corresponding potential returns. So government bonds, which are considered safest, will have less volatility but also much less exciting returns than corporate bonds, for example.

  • Real estate. With real estate, you can either invest directly by purchasing a property, or indirectly through a property investment fund. Either way, investing in real estate is often thrown into a diversified portfolio in order to have what’s often considered a “medium-risk” investment. Real estate generally mirrors how the economy in general is doing, so while periods of economic growth will likely produce high returns on real estate, economic depressions will see those returns shrink. Real estate is considered a “growth” investment—one you hold for a long time so you’re more likely to weather market instability.

  • ETFs. Exchange-traded funds are a popular asset because they have diversification built right in: They’re an investment fund that lets you buy a large basket of individual stocks or bonds in one purchase. An ETF’s risk level is going to depend on what kind of assets you choose to bundle: If you’re focusing more on bonds, then the risk level is going to be lower than it might be if you skew more heavily towards stocks.

  • Stocks. Historically, stocks—also known as equities—offer very high rates of return. But they are also one of the most volatile assets, and their range of returns can vary quite significantly (remember that standard deviation we talked about earlier). And while it may be tempting to stuff your portfolio with high-performing stocks, a diversified portfolio will ultimately take you further and help keep you calm when those prices start fluctuating wildly.

Last Updated October 10, 2018

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