Every investment carries risk. And generally speaking, the more risk an investor is willing to take, the higher the potential reward and vice versa. Understanding the investment risk associated with each decision is critical for successful long-term investing. Failing to do this will likely destroy wealth rather than create it.

With that said, let’s explore exactly what risks are associated with investing, the different types, and how to manage them within a portfolio.

What is investment risk?

Investment risk, or financial risk, is the probability that an investor will achieve less-than-expected returns. If an investment goes particularly badly, a loss may even be incurred. And it can stem from any security including:

• Stocks,
• Bonds,
• Real Estate,
• Derivatives,
• and in sporadic cases, even savings.

The reality is no investment is without risk. Even the highest-rated corporate or even government bond can still default. That’s why financial advisers recommend never investing money that an individual can’t afford to lose.

However, investors aware of the threats their portfolio faces can plan ahead. Therefore, it becomes possible to mitigate the impact of potential risks coming to pass.

Types of investment risk 

The primary types of financial risks investors have to navigate are:

• Firm-Specific Risk – Refers to any threat specific to a company, such as a revenue stream dependent on only a handful of customers. These risks can also be industry-specific. For example, a mining company could have operations significantly disrupted if there is a cave-in. Any factor that isn’t considered to be a firm-specific risk, is often classified as systematic risk or market risk.
• Economic Risk – An economy suffering a slowdown or a recession can be a challenging environment for businesses to operate in.
• Interest Rate Risk – This is the probability of interest rates being hiked by central banks like the Bank of England or the Federal Reserve. Increases in interest rates raise the cost of borrowing money, placing pressure on profit margins as well as the financial health of a business. Interest rate risk is also closely tied to inflation risk as the two entities often move in conjunction.
• Political Risk – Principally caused by a change in government which may result in changes. Business decisions made based on the previous government’s policy are affected.
• Counterparty Risk – The probability that another party in an agreement, contract, credit, investment, or trading transaction may not keep their word leading to a significant loss. 
• Liquidity Risk – When referring to a business, liquidity risk is the potential that the firm will have insufficient financial resources to meet its short-term obligations on time. When referring to a security, liquidity risk is the potential for being unable to sell the security in the future as there are no buyers.
• Concentration Risk – Investors who keep a large portion of their investment portfolio within a single asset, sector, or country are exposed to concentration risk. If something were to go wrong and the value of these investments refers to the risk associated with having one’s portfolio in a single asset, sector or country.
• Credit & Default Risk – This is the risk that a borrower will default in making a necessary payment on a debt to a lender. This risk typically only applies to financial institutions. However, in practice, any business that lends money is exposed to credit risk.
• Reinvestment Risk – Refers to the possibility of being unable to reinvest cash flow from a maturing investment at a similar rate of return.
• Horizon Risk – This is the risk that an investor’s time horizon and investment strategy may not match. Sometimes it could be cut short due to job loss or other emergencies. 
• Longevity Risk – This is the risk that an individual may live longer than expected, resulting in insufficient funds to maintain a desired lifestyle.
• Foreign Investment Risk – Refers to the risks involved with international markets, such as foreign policy or fluctuating currency exchange rates. The latter is also often referred to as currency risk.

What are “risk-free” investments?

The term risk-free investment is used to describe a group of securities that have extremely low probabilities of failing. Investors often use them to reduce the total risk associated with an investment portfolio through diversification.

Typically, the securities within this category include:

• Government Bonds.
• Treasury Bills.
• UK Gilts.
• Certificates of Deposits.
• Savings.

Despite the name, even these securities still carry a level of risk. Governments can default on their loans, and banks can go bankrupt. Even savings protected by depositor insurance can disappear if the amount stored in a bank account exceeds the insurance threshold of £85,000.

Risk vs reward 

As previously mentioned, there is generally a trade-off between risk and reward. In most cases, the higher the risk associated with an investment, the higher the potential return. This is why securities such as junk bonds and penny stocks are still immensely popular despite having high-risk profiles.

Everyone has a different tolerance for investment risk. As such, investment strategies need to reflect this risk tolerance and keep a portfolio balanced in the context of the individual investor.

How to measure investment risk

Despite being a critical piece in the world of investing, measuring risk can be tricky. Most quantitative methods used by professionals today are measures of asset price volatility. While this can provide helpful and actionable insight, it’s far from perfect, especially for thinly traded asset classes.

For example, a rare collectable may have a relatively stable price (thus low volatility), but finding an interested buyer could be challenging.

Nevertheless, the most popular methods of measuring risk/volatility include the following:

• Standard Deviation – This tool measures the historical volatility of an investment compared to its annual return. It shows how stable an asset could be. Less stable investments are known to have higher risks. Subsequently, small-cap stocks typically have a higher standard deviation than stable large-cap stocks.
• Sharpe Ratio – This metric measures the balance between risk and expected return on an investment or portfolio. The higher the value, the better.
• Beta – Measures the degree to how closely an asset price will move in relation to a stock market index. A value of 1.0 means the security will match the performance of the market. A value of 2.0 means that every time the market increases by 1%, the security will increase by 2% and vice versa. Beta values can also be negative, indicating that the security will move in the opposite direction of the market.
• Value at Risk (VaR) – Measures the level of risk an investment a company or portfolio is exposed to. Through this tool, a company could measure the maximum loss it could have. 

How to manage investment risk. 

Risk management is vital to every successful investment. No wonder Warren Buffett’s investment rules are, 

1. Never lose money.
2. Never forget Rule #1.

An investor must know how to manage investment risks within their portfolio. Fortunately, there are various methods where that can be achieved.

• Diversification – This is arguably one of the most popular and arguably most potent risk management strategies within an investor’s toolkit. For stocks, the idea is to own various high-quality businesses across multiple industries and geographies. That way, should one position suffer a loss, the impact on the overall portfolio is mitigated by the other uncorrelated investments.
• Pound Cost Averaging – During periods of stock market volatility, spreading buying activity over several weeks and months can mitigate the risk of suffering large unexpected downturns. It also ensures that capital remains available to capitalise on any adverse movements to bolster a position in a high-quality asset caught in the crossfire.
• Invest Long Term – In the long term, the stock market generally appreciates in value. Obviously, not every stock can deliver positive returns. However, by focusing on the long run, investors can largely ignore short-term risks and perhaps even capitalise on the volatility they create.
• Options & Derivatives – As an investor seeks to diversify portfolios, options and derivatives could be used as part of a hedging strategy. However, options and derivatives require skill and expertise to use correctly. A novice investor with limited knowledge of financial derivatives can potentially suffer enormous losses far greater than the initial amount invested. That’s why these securities are typically reserved for professionals.

The bottom line 

Investment risks are intrinsic to every form of investment. However, the risk levels differ from investment to investment. While risk cannot be avoided entirely, it can be minimised. And by implementing proper risk management tools, investors can potentially reap significant returns while keeping risk in check.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial adviser if necessary.