11 Investment Risks You Need To Watch Out For In Your Portfolio
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Creating a financial plan for yourself in the United States may be a completely new adventure for you as an immigrant. But, if you know what to watch out for, you’ll be able to accept the challenge with confidence.
At MYRA, our goal is to help you build an investment plan that is right for you. Here are the eleven investment risks you should watch out for when picking your investments - consider your asset allocation, risk tolerance, and time horizon when making the decision.
This article discusses the different types of risks that commonly occur in investing. In particular, the article discusses investment risk, systematic risk, and unsystematic risk.
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What Is Investment Risk?
Most investments don’t have a guaranteed rate of return. This is because when you are investing, you are taking on a certain level of risk. Each type of investment will have different types of risk.
Generally, the more risk you take, the more the potential reward will be. Alternatively, the lower the level of risk you take, the less the potential reward will be. This can be referenced in the stock market with potential returns and in the bond market with interest rates. You’ll also need to consider that an entirely risky portfolio will take large dips with the stock market, which means potential losses. Also, if you choose to take very little risk, you could miss out on potential gains.
Investment risk is the uncertainty of if an investment’s realized or actual rate of return will equal its expected rate of return. The uncertainty is due to the many types of risk discussed below.
Total risk is a combination of systematic and unsystematic risk. It is measured using the standard deviation of the ten risks discussed below. Typically, as more securities are added to the portfolio, the level of unsystematic risk decreases.
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Systematic Risk (aka Market Risk, Nondiversifiable Risk)
Systematic risk, or market risk, is integrated into the investment market. It cannot be eliminated through diversification, or the act of purposely varying the investments in your portfolio to reduce risk. This is where the risk of the overall security in the marketplace will get affected by changes in the economy.
Purchasing Power Risk (Inflation Risk)
Purchasing power risk, also known as inflation risk is the chance that inflation will decrease the real value of an investor’s assets. Fixed-income assets, like debt securities, are most affected by inflationary pressure. This is because there is no guarantee that the cash flows won’t be affected by inflation, thereby reducing their future worth.
Reinvestment Rate Risk
This is a type of risk in which proceeds that are available for reinvestment have to be reinvested at a lower rate of return than the investment that generated the proceeds.
Investments with a longer term to maturity and high interim cash flow have the highest reinvestment rate risk. Zero-coupon bonds and stocks that don't pay a dividend are not subjected to any reinvestment rate risk.
Interest Rate Risk
Interest rate risk is the chance that changes in interest rates would affect the value of the security. When interest rates rise, the value of bonds will fall, and will usually have negative effects on stocks.
Exchange Rate Risk (Currency Risk)
Exchange rate risk is the risk that a change in the value of the dollar and the value of the foreign currency during the period of the investment will affect the investor’s return negatively.
Exchange rate risk can affect investments in a foreign company or a domestic company that has supplies or customers in other countries.
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Unsystematic Risk (a.k.a. Non-Market Risk, Diversifiable Risk)
Unsystematic risk is unique to a single security, business, industry, or country. This risk can be reduced by having a portfolio with as few as ten stocks. In other words, diversifying your investments can drastically reduce the chance of unsystematic risk. There are many different types of unsystematic risks.
The first type is business risk. It is considered to be the uncertainty of operating income. Utility companies have relatively steady and stable income streams and are considered to have a lower business risk. However, companies such as auto manufacturers have unsteady operating income levels and therefore have a greater business risk.
The second type of risk is financial risk, which is the risk that a firm’s financial structure will negatively affect the value of the investment. Businesses, government entities, financial markets, and individuals can all be subjected to financial risk. For instance, a company’s cash flow could not be enough to cover their liabilities or a government could default on its bonds.
Another type of unsystematic risk is default risk. Default risk is the risk that a borrower will be unable to satisfy its debt obligation. Bond-rating agencies rate bonds issued by corporations and municipalities for their likelihood of defaulting. Obligations of the U.S. government are considered default-risk free. The greater the risk, the higher the interest rate. However, this risk does not apply to stocks, and bonds with more default risk usually have greater interest rate risk.
Additionally, political risk is another type of unsystematic risk. This is the risk that the politics or economy of a country can negatively affect investments. The United States is considered to have a low political risk, while foreign investments will have a higher political risk. Some examples of political risk include trade barriers, taxes, legislation, and administration.
Investment Manager Risk
Investment manager risk is the risk that is associated with the skills of the manager of an investment fund or account. It can refer to changes in the investment style or the change in the management team. Essentially, all losses resulting from mistakes, negligence, and incompetence of the managers of a financial portfolio would fall under investment manager risk.
Liquidity Risk (Marketability Risk)
Liquidity risk reflects the ability to sell an investment quickly at a competitive price. Marketability risk is the ability to find a ready market where the investor can sell the investment.
Real estate is marketable, but not usually liquid. Alternatively, treasury bills are both liquid and marketable. Due to this, cash is the most liquid and marketable asset. If an investment is less liquid or less marketable it will exhibit more risk.
The last type of risk is called a tax risk, which illustrates the chance that taxation of investment gains or losses can negatively affect the return of an investment. This could occur if a business does not accurately account for taxes. This would lower the amount of profits and returns to stakeholders.
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You Must Understand Your Risk Tolerance
Overall, you must diversify your investments when possible to reduce your level of unsystematic risk. However, keep in mind that systematic risk is out of your control and dependent upon the economy. When determining what you want to invest your hard-earned money in, consider what appropriate asset allocation is for your age, risk tolerance, and time horizon. If you do that, you’ll be well on your way to creating a strong financial future.