Common types of investment risk

Successful investing rests upon understanding, accepting and managing the various types of investment risk you face.

The decisions we make today have to interact with the future before we know whether the correct decisions have been made; i.e. whether we have effectively managed investment risk to achieve the returns available, or whether we have simply received the risk of investing.

Financial professionals commonly use a single measure of investment risk, which is standard deviation, or the measurement of volatility. But one number will not completely measure all of the investment risk you will face as investors.

It is therefore important to remember that risk is subjective. I like to think of it as a moving target affected by a variety of factors and market pricing.

It’s always useful to remember different types of risk are inherent within different investments and these may not necessarily be reflected in historical volatility measurements.

Here are a few of these risks that your investments are exposed to.

Inflation risk

I expect inflation is one of the main reasons so many people invest in the first place.

Whilst keeping funds on deposit in the bank provides very high security for the return of your capital; it is still exposed to the threat of inflation, and in particular periods of high inflation.

The low deposit returns available and the constant perceived threat of inflation, drive many everyday people to become investors, perhaps even reluctantly.

Whilst it would be obvious to suggest a great majority of the population would be better off simply having higher deposit rates, low inflation and not having to invest in anything other than cash; this is a utopia that is never going to be achieved and therefore you have to accept other types of risk in your attempt to avoid the risk of inflation, and obtain enough return to meet your goals.

Capital risk

Every investment carries with it some risk that you won’t get back your original investment capital.

At the very basic level, a share in a company has a higher risk of outright capital loss than a bond, but for practical purposes, these types of risks have already been diversified away via fund management and indexing.

With a well-diversified multi asset portfolio that most financial advisers/planners would recommend, the likelihood of outright capital loss over a long time horizon is so small that it is practically irrelevant, however when you introduce your own personal life goals and timespans, it remains an essential part of your investment planning.

Whilst a 50-year chart will show that you don’t really have much to worry about when investing, how many of you truly have this level of time horizon? We all understand the long-term benefits of investing, yet we all have both shorter-term mindsets and shorter-term needs.

This makes capital risk a very real concern and explains why the measurement of volatility and risk profiling become key financial planning factors.

Interest rate risk

The rate of interest plays a particularly crucial role in determining the price of bonds, and therefore indirectly the price of other assets.

When the Bank of England base rate is 0.5%, it explains a great part of why we see 15-year government bond yields of 1.38%.

When the Bank of England base rate is 5% for example, bonds will be providing a yield that is too low and the reason is simple.

If you can obtain a yield of say 6% from a Bank deposit, why would you accept the risk of capital loss for an investment yielding anything less?

Thus you can conclude that the interest rate acts like gravity on prices when rates rise, and a pump on prices when rates decline.

The simple inverse relationship, as follows:

Interest rates DOWN, bond prices UP

Interest rates UP, bond prices DOWN

Liquidity risk

The importance of liquidity is usually underestimated until it is needed.

Whist liquidity isn’t such an important issue for large endowments and pension funds with very long timespans and measurable cash flow needs, I feel it is a crucial factor for everyday investors because you are much more reliant upon your investment assets for your lifestyle needs (many of which are unpredictable in nature).

Owning a portfolio of securities that have a large market demand and traded daily is far more liquid than owning one property that can take years to find the right buyer, and months to complete the sale.

With liquidity comes the possibility that you may have to accept a price you do not want, but at least you can accept some price. If you have a truly illiquid investment you can find yourselves unable to obtain any cash for your asset, at least not when you need it.

This can further exacerbate any financial difficulties you are experiencing.

Currency risk

If you invest outside of the UK, you expose yourself to currency risk, i.e. the investment asset may nominally perform well, but the return you receive in sterling is eroded by currency fluctuations.

It’s also worth mentioning that having your finances entirely in one currency also means that you are taking currency risk, at least at the extreme end.

If you have all your assets in a currency that becomes worth considerably less compared to other currencies, then you will have lost a considerable amount of your purchasing power. This would more properly be classified as high inflation risk, but I feel it would be wrong to conclude that having all of your finances exposed to one currency is lower risk than allocating your finances with a global mindset.

If all your expenses are in one particular currency however, currency risk becomes particularly acute.

Leverage risk

Using leverage to fuel investments is in my view, a little like an athlete taking performance-enhancing drugs – I regard it as akin to financial cheating.

I understand why leverage is so popular, but at best it is dangerous.

If you only have savings of £10,000, it’s rather tempting to borrow £90,000 and then invest £100,000, than it is to only invest with your own £10,000.

If you obtain a 10% return on £10,000, you only gain £1,000.

However if you obtain a 10% return on £100,000, you gain £10,000, therefore actually doubling your initial investment.

However leverage not only magnifies gains, it magnifies losses.

A 10% decline on your un-leveraged £10,000 investment still leaves you with £9,000 of capital.

A 10% decline on your leveraged £100,000, essentially wipes out all of your capital.

Leverage appears to have the force of magic when it works, but when it doesn’t the consequences are disastrous.

The risk of leverage becomes particularly severe when combined with some of the other risks mentioned, such as illiquidity, rising interest rates and currency fluctuations.

Despite history showing us many examples of leverage caused financial messes, the attractiveness of magnifying available investment gains indicate that we are likely to repeat the same mistakes.

This isn’t an exhaustive list of the different types of investment risk we face, but should be helpful to illustrate that risk means more than just a number.

Make sure you understand all of the investment risks you are accepting when managing your finances and don’t lose your shirt.