Risks of Investing
Investing can be risky. And often, high risk can mean a high reward. But that doesn’t mean any high-risk investment is going to be worth it in the long run. Learn more about how to evaluate the risk and reward of any investment you’re thinking about making before you tie up your money.
What is a Risk?
The U.S. Securities and Exchange Commission defines the risks of investing as uncertainty and the potential of losing on an investment. Such a broad definition covers many things. Risk is like ice cream; it comes in many varieties. Each type of risk has specific issues that may cause uncertainty that leads to a loss.
There is a common belief that risk and reward correlate with high reward investments having high risk. While this belief may generally be true, it may create a false sense of security that comes from holding low-reward investments. Low-reward investments may have surprisingly high risks, some hidden, such as inflationary risk.
A potential investment strategy that balances the risks and rewards of investing is to seek low-risk, high-reward investments instead of high-risk, high-reward investments. In other words, clever investors try to reduce their investment risk that produces a higher reward.
Business risk is the category of many things that might cause a business to lose value or fail. Business risk includes competitive pressures, market dynamics and general economic circumstances.
Some business risks are manageable, like providing excellent customer service to maintain a customer base. Other business risks may come from circumstances that are a surprise, such as the shutdowns and supply chain disruptions caused by a global pandemic.
Market Volatility Risk
Market volatility represents the ups and downs in the valuation of an investment caused by changes in overall investors' sentiment. A highly volatile market has sharp price increases or decreases.
Many investors consider high volatility increased risk. However, frequent traders may enjoy highly volatile investments that they buy and sell rapidly to capture profits from oscillating price movements.
The Chicago Board Options Exchange's CBOE Volatility Index (VIX) measures overall stock market volatility that tracks the values of the S&P 500. When VIX is down, market volatility is less. When VIX is higher, market volatility is greater. Usually, high VIX accompanies a greater general level of investor fear.
Inflation risk is the reduction in purchasing power over time. As prices go up due to inflation, the currency used to buy those items goes down in value.
Inflation is a somewhat less visible risk for investments that may, at first, seem to be a low risk—for example, depositing money in a bank account that pays less than the annual inflation rate means that money is losing value over time. While a bank account may be considered a safe investment, in reality, a low-interest bank account is a guaranteed losing investment, and that is what are high-risk investments, hidden in plain sight.
Political risk comes from any governmental action or mass movement that causes investments to lose value.
An example of political risk came when the Chinese government recently outlawed everything to do with cryptocurrencies. This political move suddenly made illegal all the cryptocurrencies in China and everything related to it. Chinese holders of cryptocurrencies lost money. Cryptocurrency trading exchanges in China closed. Profitable companies creating cryptocurrency were suddenly put out of business and suffered tremendous losses.
Interest Rate Risk
Interest rate risk comes from the impact of rising interest rates on the value of an investment.
Homes sell more easily when interest rates are low and when home loans are easy to get. In the 2008 real estate market collapse, millions of people lost their homes due to foreclosure. This loss happened because they could not afford increased monthly mortgage payments caused by the interest rates rising on their variable-interest-rate loans.
Liquidity risk is a problem an investor might have when trying to sell an investment for a fair price because of the lack of a market for the item and few buyers.
A liquid investment sells easily and converts to cash. An illiquid investment may have significant value, but be difficult to convert to cash when needed to be sold—for example, real estate can take time to sell and thus is considered a less liquid investment.
Examples of High-Risk Investment
Examples of high-risk investments include anything that has a low probability of succeeding. Loaning money to someone in the middle of bankruptcy, which is an example of a high-risk investment, probably isn’t a good idea no matter how much interest they are willing to pay.
Making your retirement plans depend on winning the lotto by taking all your savings and buying lotto tickets is a silly but clear example of what is a high-risk investment that most likely isn’t going to be in your best financial interest.
Some common things found in high-risk investments are that they often sound "too good to be true." Investors sometimes invest in high-risk opportunities because they’re not sophisticated investors and don’t know how to conduct proper due diligence. A strategy of some investors is to intentionally make a high-risk investment, such as wildcatting to drill for oil because of the rewards of investing in high-reward investments.
Risk and Rewards in Investing
What are the risks and rewards of investing? There are the risks of losing everything compared to the rewards of making a fortune. There is also the opportunity cost of not investing. Opportunity cost is what is lost by not investing. A young adult who doesn’t save for retirement to benefit over many years from compounding annual increases may lack sufficient resources in retirement.
Risk and Diversification
One possible way to mitigate risk is through diversification of your investment portfolio. Diversification can be beneficial because in a portfolio with balanced risk, there’s an allocation of investment classes from low to higher risk in different sectors and types of investment. The idea is that if one part of a balanced risk portfolio goes down in value, the other parts(s) may go up to offset any losses.
The S&P 500 index is an average of 500 publicly traded companies. The annual return of the S&P 500 index is a useful benchmark for an investor to use to measure the effectiveness of their portfolio's return
It’s so important for investors to know and identify risks ahead of time. Savvy investors may be more willing to make risky investments with confidence they’ll pay off, but you can be sure they’ve done their homework and researched any investment they make before taking that leap of faith.
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