What Types Of Risks Should I Be Concerned About When Investing?
- Understanding the various risks associated with each investment strategy will help you make proper comparisons and help you choose what’s right for your unique situation.
- Taking more risk does not automatically mean you will get a better rate of return. Taking more risk means you get more risk – with potential.
- Major risks associated with every investment include business risk, market risk, credit risk, liquidity risk, interest rate risk, and regulator risk.
We all know that, by definition, investments have risk of loss. We normally think of risk as simply the possibility of losing money in an investment, but to properly assess what investment is right for your unique situation, you need to have the ability to analyze the risks associated with the specific investment strategy you are considering.
Take rental real estate, for example. Personally, I love real estate as an investment, but there are a lot of risks associated with buying and managing rental properties. A neighbor of mine, for example, was renting one of his properties to a family who let their 10-year-old son light fireworks inside the house. Not only did the entire unit burn down, but it did significant damage to other units in the building. Luckily, no one was hurt. Sure, insurance covered the damage, but he lost 10 months of rent while rebuilding and his insurance rates increased making future rental income less profitable.
A second obvious risk to real estate is the overall real estate market in your area. Given the rise in real estate prices in the last few years, many investors have convinced themselves that real estate is a risk-free investment. I hear things like “real estate is a limited resource, there is always demand for it,” or “I can always find renters, so I can’t lose.” The reality is there is always volatility in the demand for any asset which means there is always risk of loss.
Look at the chart below. The S&P/Case-Shiller U.S. National Home Price Index© is one-way economists gauge the price of real estate. In the period between 2008 and 2012, the index was down 29.6%, and did not recover until 2017. Unless your intent was to hold for 10 years, you probably lost money. So, as much as national real estate prices have increased in the last few years, there are always going to be periods of time where you can lose.
Investing is a constant process of compromise – weighing the risk of doing something, compared to the potential return you may receive. There is no such thing as a risk-free investment. If there were, the investment industry would not exist, and we’d all be rich.
Talking to clients over the years, I have come to the realization that people who are new to investing seem to have a fundamental misunderstanding of risk. There seems to be a belief that “taking more risk means I will make more” – “taking less risk means I will make less”. Losing money is never real until it’s too late, the loss has already happened.
Investing, by definition, is about taking risk. As an advisor, I often told my clients that my job was not to make money for them, but to help them manage their risk.
Your ability to choose the correct investment opportunity may have more to do with your ability to understand risk than your ability to choose the strategy with the greatest potential return.
Types of investment risk
To define risk, consider the investment you are thinking about making, and think of everything bad that could happen. In finance, we define risk in several specific ways.
When we think of risk when investing in the stock market, this is the one we are thinking about. Business risks are the risks unique to the specific corporation we are buying into and arise out of the company’s core business activity. For example, let’s say you are considering purchasing some shares of Apple since you love their phones? What could happen that could cause their stock price to decline? Maybe another company, like Google, invents a revolutionary new phone technology that makes the iPhone obsolete? How likely is this to happen?
Things to consider when assessing a company’s business risk:
- How will changes in the price of raw materials, labor and other costs affect the profitability or the company or asset?
- Are you comfortable with the company’s business model and its ability to maintain profitability in the face of competition and technological change?
- Are you confident in the management team?
- Do you believe in the company’s marketing formula and plans for future growth?
Market risk the risk of the overall market changing in such a way that the price of your asset will decrease. You may have done your homework and chosen the best company in the world to purchase stock in, but even good stocks tend to decline when the broader markets decline. Stocks within industries tend to move together. Even very profitable companies will see stocks decline if their industry is declining.
In real estate terms, there are a ton of market risks. A great example; I have a friend who focused on purchasing real estate in Atlantic city. His theory was that people are always going to want to gamble so the city will always do well. The problem that has happened is today, we have legal gambling in some form in 48 State, so Atlantic city has lost its uniqueness. Business is declining and so has real estate prices. He lost money not because the specific home he purchased was a bad property, but because the entire city’s real estate values declined.
Here are considerations when assessing market risk:
- How is your specific asset correlated with other investments with its market? Proper investment diversification can go a long way to managing market risk.
- Historically speaking, how has your asset been affected by past market swings, and how long did it take to recover?
- How does the state of the overall economy affect your market and your specific asset?
Credit risk is the risk of default on debt. When changes in the financial situation of the entity you are investing in occur, there is the possibility that outstanding loans will not be paid, affecting the value of stocks, bonds and other assets. Credit risk can be incurred by corporations like banks who loan to customers who may not pay the funds back, affecting their future profitability. It can also affect stock holder’s when the company they are investing in borrows money from the public and finds itself in a situation where they can’t pay the money back. Bankruptcy will eventually occur along with significant decline in stock price.
But, the biggest source of credit risk is to individual investors who choose to purchase bonds or bond mutual funds. A bond represents money loaned directly to a business. If the business can’t pay you back, you’ll lose most, if not all of your investment.
Here are considerations when assessing credit risk:
- How much debt is involved in the investment you are considering? More debt means more risk.
- If purchasing bonds, are they backed by assets, or the general credit of the company?
- What is the credit rating of the company you are loaning money to?
Investing is about buying an asset, holding it for a predetermined period, and then selling it, hopefully at a profit. But what if, when you are ready to sell, there are no buyers? Liquidity risk is associated with your ability to turn your asset into cash and the amount of time necessary to complete that transaction.
Assets with numismatic value are a great example of an asset with huge liquidity risk. You may believe that rare stamp or well-known comic book has value, but until you find a buyer for it, you really have a value of zero. Additionally, how long will it take to find a buyer?
Liquidity risk can also affect you if your timing is off. The stock market is a great example of an asset that tends to increase in value in the long run, but also suffers significant volatility within shorter time periods. If you were planning to retire just after the 2001 crash, or the 2008 crash, you would be forced to liquidate a portion of your assets at the market low, locking in losses with no ability to recover over the long-term.
The biggest complaint about insurance products, both annuities and life insurance, is the lack of liquidity, and that is defiantly a concern. Most deferred annuities require you to hold for a minimum period, say 7 years, or suffer significant surrender charges, sometimes over 10%. That doesn’t make annuities bad investment though. You need to go in knowing what you’re doing, and only invest a portion of your funds you are sure you have no need for within the surrender period.
Here are some considerations when assessing liquidity risk:
- What percentage of your available funds are you investing? Small investments can be invested for longer periods, as long as you have cash flow to cover your daily, monthly, or annual needs.
- How long are willing to leave your funds in the investment? Do you know how to sell?
- How likely is it that your situation could change forcing you to sell before the hold period anticipated?
Interest rate risk
This is a huge one, especially in today’s highly manipulated and controlled economy. Generally, asset prices are inverse of interest rates, so when interest rates rise, the price of your stock, your bond, or your real estate will decline.
Rising interest rates affect stock prices because of the associated rise in borrowing cost. If Apple wants to borrow money to build a new factory, lower interest rates assures greater profitability in the future since they can lock in a lower fixed payment.
Real estate also tends to decline in a rising interest rate environment, since demand for real estate is largely dependent on the availably and affordability of mortgages. For a $250,000 mortgage, a 1% increase in interest rate translates to an increased monthly payment of about $150, every month for the next 30-years. That’s a significant impact on the affordability of buying a home.
Fluctuations in interest rates affect the prices of bonds more than any other investment. A bond is a loan to a business which generally carries an annual interest payment based on the bond’s coupon or interest rate. A $10,000 loan with a 10% coupon, for example, will pay $1,000 per year in interest payment. At the end of the holding period – called maturity, the original $10,000 is returned. But, if you need to sell your bond before maturity, your sale price is dependent on interest rates. If rates have increase, you will be forced to sell at a price less than what you originally paid.
Here are some considerations when assessing interest rate risk:
- Where do you expect interest rates to go during your investment hold period? While we can’t predict the future, right now, 2018, we are in a rising interest rate environment. Bonds are riskier that they have been in the past.
Government’s effect on the value of your investment can not be understated. Changes in government regulation can affect the profitability of companies you invest in. Changes in tax policy can affect the value of specific strategies such as retirement plans and insurance products. Governments can even manipulate markets and entire economies for political purposes. Unless you know ahead of time what the various city, county, State, and Federal law changes are going to be, you need to be ready to absorb losses resulting from regulation changes that affect you negatively.
Here are some considerations when assessing regulator risk:
- For shorter term investments, how would a major regulation change affect value, and how close are we to the next election that could bring about that change?
- For very long-term investments such as retirement plans and insurance products, are you willing to risk the chance that a desperate government decades into the future doesn’t attempt to increase revenue by taxing strategies that are currently tax advantaged.
Understanding the risks that can cause you to lose money is important to giving you the ability to properly assess the value of the different investments you are presented with. If you are just looking at the historical rate of return and ignoring all of the worst-case situations that could affect you, you are missing an important component in investment analysis.