Whenever you make the decision to invest, you are entering into a risk-reward tradeoff. The amount of risk you accept will determine how much potential reward you might earn. While each individual’s tolerance for risk may differ, understanding the different types of risks will help you make sound decisions and give you the tools you need to make informed choices. Let's take a deep dive into what investment risk is and how you can manage it.
The Reality of Risk
Before effectively mitigating investment risk, you need to understand what it is and how it can impact your portfolio.
The first thing to note is that, in general, risk and reward are inversely related. Put another way, the more risk you accept, the greater the potential for larger returns. At the same time, increased risks often result in the potential for greater losses.
Risk and reward have a two-way relationship. As you increase your potential to earn more—by taking on more risk—that same decision increases the potential for loss. In fact, some of the very investments that offer the highest potential returns also carry the most significant potential for loss.
The Risk Spectrum
When it comes to assessing risk, it helps to visualise the continuum. The first step is to determine whether a risk is market-related or credit-related. If the risk is market-related, it means the likelihood of realising a loss is due to market forces—market movements, market volatility, stock-specific risk, or interest rate risk. If it's credit-related, the risk is the result of the company or individual you're lending your money to. This can be based on the creditworthiness of the borrower or whether the investments are secured by collateral.
It's essential to understand the risks that come with each type of investment. For example, risk related to the financial health of the borrower is a risk you will take when you purchase a bond. On the other hand, the risks that come with investing in the stock market are largely based on the performance of the stock itself.
The Challenge of Creating Risk Measures
While we understand the concepts related to risk, when it comes to quantifying risk, we often find ourselves at a loss. This is because risk is often measured in relative terms, which are subjective.
When you assess risk, it's important to look at the big picture. With any investment, you should ask yourself how likely it is that it might move in the opposite direction of your expectations. The higher the likelihood, the greater the risk.
The challenge, of course, is figuring out what to measure and how to measure it. Some investors, for instance, look at the volatility of an investment to get a measure of its risk. However, depending on the context, a volatile investment could still be a good investment. The key to determining the risk is to take into account the likelihood of realising the loss and the potential size of that loss.
Which Measures Matter Most
While we understand the concepts related to risk, when it comes to quantifying risk, we often find ourselves at a loss. This is because risk is often measured in relative terms, which are subjective. However, there's a simple way of understanding the different risks.
Known Risks: The likelihood of a loss is known or quantifiable and acknowledged. Examples include the possibility of stock prices falling below a stock's purchase price, a bond issuer defaulting, or the possibility that a company will go out of business.
Unknowable Risk: The likelihood of a loss is unknown or unquantifiable. Examples include the disruption of an industry or a natural disaster that causes a loss in an otherwise profitable company.
Most investors are aware of the risks associated with investing. However, few have a good sense of the risks they're facing or of how to manage risk in their portfolio. By understanding the investment risk and by being aware of the risks you face, you can be better prepared to make smart investment decisions.
If you want to manage investment risk and make better investment decisions, seeking help from a professional goes a long way. Swell Financial Planning is here to provide tailored solutions to help you achieve your dreams in as little time as possible. We'll work with you to develop what strategy works for you in the long run. Contact an investment adviser in Gold Coast today and let our team help you.