“Life is inherently risky. There is only one big risk you should avoid at all costs, and that is the risk of doing nothing.“
There are many decisions that go into financial investment and planning needs. The question that is likely to have the greatest impact on the financial future is how much investment risk will an investor will take.
A life without risk is impossible. Risk is everywhere – even walking down the street comes with a small risk. Whatever a person is doing in life, it is important to understand his tolerance for risk. An investor may feel more comfortable limiting the amount of risk that is exposed to by not participating in certain activities or may prefer to take more of a risk in the hope of achieving greater rewards.
Some level of risk will always be present, no matter what an investor does with his investments. It’s important to understand this from the start. There are many different types of risks involved in investing. Understanding them can help everyone involved make the most appropriate decisions.
The most usual types of Investment Risks are:
Market Risk, sometimes called volatility, is the risk that an investment will be unpredictable and may fall. They can do this at any time, mildly or severely, for any number of reasons. All investors must plan for losses at some stage. The nature of stock markets makes them unavoidable.
Inflation Risk is the risk that a return is below the rate of inflation. Over a long time, this can reduce the purchasing power of the wealth even though an investor may not feel you have lost anything in numeric terms. Cash is especially vulnerable to the impact of inflation.
Interest Rate Risk is the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates. Interest rate risk is mostly associated with fixed-income assets rather than with equity investments. The interest rate is one of the primary drivers of a bond’s price.
Opportunity Cost Risk is the risk that an investor misses one opportunity by taking another, and that the one the investor didn’t take would have brought a better result.
Credit or Counterparty Risk is the risk of an investment product provider going bust.
Liquidity Risk is the risk that an asset cannot be sold when you wish to sell it.
Shortfall Risk is the risk that a portfolio will not generate a rate of return sufficient to meet an investment goal. This may be because of lower market returns or because it has not taken sufficient risk within the portfolio to generate the required return. The magnitude and consequences of the potential shortfall deserve special consideration from investors.
Exchange Rate Risk is the risk that the exchange rate moves against the initial investment when investing in an asset that is priced in a currency other than the local currency.
Country Risk is the risk of the degree to which political and economic unrest affect the investment of doing business in a particular country.
The Risk Profile is a level of investment risk that is right for an investor at a certain time and for a given financial objective. The ideal risk profile will give to an investor a realistic chance of achieving what he wants, with an acceptable level of uncertainty attached.
The Investor Risk Profile will consist of the following four areas:
Risk Tolerance is how an investor feels about investment risk. It’s about the psychology of taking risks with money. How will an investor react if there is a sharp market fall? Will investing become a source of stress and anxiety for an investor, or will he be relaxed as markets go through their natural cycles?
Capacity for Loss looks at the overall financial position. Can an investor afford to make a long-term investment and to take the risk of losing money? What proportion of his total wealth is invested? Ideally, an investor would not have to access his investment in an emergency and sell during a market low.
Investment Objectives are about what an investor wants his wealth to do for him in the future. Buying a house or a car, saving for a comfortable retirement or leaving a legacy to loved ones are all possible goals. The investment objectives reflect the type of person that the investor is and his priorities in life.
Knowledge and Experience is there to ascertain investor understanding of different investment types and to learn more about his past experience with investing.
Volatility is a common way to measure the uncertainty, or degree of daily change, in the value of a portfolio. Investors want returns based on how much risk they accept in an investment. Usually, the higher the risk, the better the reward and vice versa.
The investor risk profile is usually assessed by using a questionnaire.