All investments carry risk. It’s inherent, multifaceted, and ever-present. It can also be said that risk is a prerequisite for growth. As the saying goes, “The higher the risk, the bigger the reward.” And while you can’t eliminate investment risks, understanding them is crucial for constructing and managing your portfolio. This article discusses five key investment risks and explores strategies to mitigate them.
Market Risk
Also known as systematic risk, it is the risk that the entire market or a substantial segment of it will experience a decline, regardless of the individual strengths or weaknesses of the specific companies or assets within that market. As such, it is the broadest and most pervasive type of risk.
Factors such as economic recessions, shifts in geopolitical stability, monetary policy, widespread investor fear, or even natural disasters can trigger market risk. Importantly, because it’s a risk inherent to the overall system, it cannot be eliminated through diversification, meaning even a well-allocated, balanced portfolio is vulnerable to the general movements of the market.
For example, the Covid-19 pandemic triggered widespread economic shutdowns, supply chain disruptions, and shifts in consumer behavior, all leading to significant market volatility. President Trump’s tariff policies are another example of a major factor that impacts various aspects of the economy and thus people’s investments.
Specific Risk
This type of risk is confined to the fortunes of a single company, industry, or asset. Unlike market risk, which casts a wide net, specific risk is exactly that: specific.
It stems from internal, localized issues, such as poor corporate governance, labor disputes, regulatory setbacks, the failure of a key product line, or unexpected lawsuits.
A key characteristic of specific risk is that it is the only investment risk that can be largely mitigated through diversification. If you hold a portfolio that includes different, unrelated assets across various industries, a decline of any one component will have a minimal, cushioned effect on your overall returns.
Inflation Risk
This is the risk that the returns you earn on your investments will not keep pace with the rising cost of goods and services, effectively eroding the real value of your money over time. While your money may grow nominally, its purchasing power, or what it can buy, is less.
Factors that contribute to inflation include monetary policy, aggregate demand and supply dynamics, rising production costs, and supply chain disruptions. The main problem about inflation risk is that it erodes your money silently. What could buy a lavish retirement lifestyle today might only afford a modest one in 30 years if inflation is not taken into account. Consider this hypothetical scenario:
Say you meticulously save $100,000 for retirement, expecting it to be sufficient for a comfortable lifestyle in 20 years. You invest this money in a low-risk bond that yields an average annual return of 2%. However, over the same period, the average yearly inflation rate hovers around 3%. While your $100,000 technically grows to approximately $148,000 nominally, the real purchasing power of that money, adjusted for inflation, would be closer to $82,000. This means your growth has been outpaced by inflation.
Interest Rate Risk
Interest rate risk primarily concerns fixed-income investments, such as bonds. It’s the risk that changes in prevailing interest rates will negatively impact the value of existing bonds. The inverse relationship between interest rates and bond prices is a fundamental concept in financial markets.
When central banks or market forces cause interest rates to rise, newly issued bonds offer higher coupon payments or yields to attract investors. Consequently, older bonds with lower fixed coupon payments become less attractive. To sell these older, less appealing bonds in the secondary market, their price must be lowered to make their effective yield competitive with the new, higher-rate bonds. Conversely, if interest rates fall, existing bonds with higher yields become more desirable, and their market price increases.
Imagine you purchase a 10-year corporate bond with a face value of $1,000 and a fixed annual coupon rate of 3%. Six months later, the Federal Reserve raises its benchmark interest rate, leading to an overall increase in market interest rates. Now, new 10-year corporate bonds of similar quality are being issued at a 5% coupon rate. Your existing 3% bond is now less desirable. If you needed to sell the bond before maturity, you’d likely have to sell below it’s $1,000 face value to make its effective yield competitive.
Liquidity Risk
This is the risk that you won’t be able to sell an asset quickly enough to prevent a loss or meet a pressing need, or that you’ll be forced to sell it at a deeply discounted price. A highly liquid asset, like publicly traded stocks, can be converted rapidly. On the other hand, real estate may take a long time to sell or potentially require price concessions.
Factors that affect liquidity include market depth (the number of buyers and sellers for a particular asset), trading volume, asset type, and prevailing economic conditions. Managing liquidity risk involves ensuring that you have sufficient access to cash or readily convertible assets to meet your financial obligations and emergencies without being forced to sell valuable, long-term investments.
For example, compare owning two types of investments. One is 10,000 shares in a blue-chip company traded on Wall Street. Another is a 10,000 limited partnership stake in a private real estate development. If you need that 10,000 immediately, you can typically sell the blue-chip shares within minutes during market hours, and the transaction wouldn’t significantly impact the stock’s price. In contrast, you’d have to wait longer to sell the partnership stakes. If you are pressed for time, you’d probably be forced to sell at a lower price just to sell it quickly.
Tips To Mitigate Investment Risks
1. Diversify
The most effective defense against most investment risks is to hold a portfolio of assets across various industries, sectors, and companies. This ensures that the failure or poor performance of an asset has only a minimal impact on your overall returns. You may consider investing in low-cost index funds or ETFs to achieve instant, broad diversification.
2. Adopt A Long-Term Perspective
Time is your greatest financial tool. Market downturns are cyclical, and major markets have always historically recovered. For long-term goals, such as retirement, maintain your investment through periods of volatility. Remember, time in the market is often better than trying to time the market. With this, you can also maximize the power of compounding.
3. Hedge Against Inflation
Invest in instruments like Treasury Inflation-Protected Securities (TIPS), whose principal value adjusts upward with inflation. You may also focus on growth assets, such as real estate and stocks, which have historically outpaced inflation.
4. Build A Bond Ladder
If you are interested in bonds, consider purchasing bonds with staggered maturity dates (e.g., 2, 4, 6, 8, and 10 years). As the short-term bonds mature, you reinvest the proceeds at the prevailing market interest rate. This allows your portfolio to capture rising rates without selling bonds at a loss.
5. Maintain An Emergency Fund
Keep a separate, highly liquid cash reserve sufficient to cover at least six months of living expenses. This prevents you from being forced to sell long-term investments at a loss when immediate cash is needed. Ensure to keep your emergency fund in a separate account and to replenish it whenever you use it.
Final Thoughts
Investing entails risk. You cannot escape it. The faster you accept that, the more you will be able to prepare and mitigate these investment risks. Diversify. Do not put your eggs in one basket. Use laddering or hedging as added strategies. Do not neglect building an emergency fund and focus on the long term. You may also consult a professional financial or investment advisor for tailored guidance.