Note: This is a guest post was authored by Sahil Vakil, CEO of MYRA Wealth. MYRA Wealth provides personal finance services for international and multicultural families in the United States.
What is investment risk, what shape does it take and how does risk affect your personal financial planning? Investment risk is a complex topic, but every investor should have at least a basic grasp of investment risk in order to make wise investment decisions. In this article, we cover the basics around investment risk and explain how and why your approach to investment risk should adjust over time.
Defining investment risk
Investment risk is the likelihood of a financial loss that is caused by an investment. FINRA (The Financial Industry Regulatory Authority) defines investment risk as uncertainty with respect to your investments. It is the probability that upon selling an investment you will receive less than you originally invested, or that the investment return on an asset fails to meet your expectations.
Low risk means a relatively predictable outcome, high risk means that there is a lot of uncertainty about your investment outcome. It is important to understand that investment return and investment risk is directly related.
Investments with higher returns are also often investments carrying higher risk. The market rewards investors willing to accept a higher probability of loss in return for the opportunity to see a high return. However, some investment risk can be mitigated. By mitigating investment risk you can ensure your portfolio is located on the ‘efficient frontier’. In layman’s terms this means that you get the highest returns for a given level of risk, or are exposed to the minimum of risk for a desired level of investment return.
Types of investment risk
Investment risk can be classified under an almost countless number of categories, but when investing your own money it is worth looking at investment risk from two perspectives.
Systematic (or Non-Diversifiable) risk
Some risks are very difficult to avoid because they are intrinsic to the financial system, or indeed to a specific asset class. It may be difficult to avoid systematic risk, but you can reduce your risk exposure by changing the asset class, or by adjusting your financial planning. Some examples of systematic risk include:
Locking in a high savings account rate may look attractive, but it can cost you if inflation rises. Though the outlook for inflation is generally stable, investors should consider the risk of rising inflation as inflation can rapidly reduce the value of your money.
Entire markets can swing, leaving every asset in an asset class such as stocks nursing heavy losses. The strong downturn in the stock market after the 2008 financial crisis is one example of market risk.
Exchange rate risk
In some countries, exchange rates can rapidly change, devaluing investments held in that currency. The opposite can also happen: if you plan on moving back to your home country from the US you may find your dollar-denominated assets can suddenly lose relative value if your home country’s currency stages a recovery.
Systematic risks cannot be fully avoided but a degree of planning can compensate for systematic risks. Systematic risks are also worth staying ahead of so that you avoid underestimating your overall investment risk.
Unsystematic (or Diversifiable) risk
Some types of investment risk affect individual assets such as specific stocks rather than entire markets. Also known as unsystematic risk, these diversifiable risks can be mitigated by spreading your investments across multiple assets. Diversifiable risk includes:
Regulatory and business risk
Governments can put large companies out of business rapidly, or at least reduce their ability to produce profits. Just think about environmental regulation, for example. Likewise with regards to competition, consumer preferences and technological advances all of which can quickly reduce the prospects of a corporation.
Corporations use debt to finance their activities, and for the most part, this causes no problems. However corporate debt can suddenly spiral out of control, leading to difficulties repaying debt and a contraction in profits or in the worse cases, default, and collapse of the corporation.
Unexpected events can impact the ability of a company to maintain growth and profits. Examples include natural disasters, a customer service fiasco or large hacking attacks that lead to financial loss or data loss and the associated bad publicity.
Diversifiable risks are highly unpredictable, but by holding a range of assets (such as a basket of stocks in an ETF) you can reduce the impact of any one stock that suffers large losses. It is worth diversifying not only across companies but also across industries and asset classes.
Adjusting your risk exposure
One of the laws of investing is that returns even out over time. This is known as ‘mean reversion’ – your investment returns will tend to match average returns in the long run. What you lose during one period you will probably later gain over another period – if you invest wisely, of course. In time frames stretching decades chances are you will have the opportunity to make up for losses, so you can take risks.
Deciding how much risk you take on when investing your personal finances depends in part on when you’ll need access to your money. If you have no looming large expenses such as a mortgage deposit, children’s college fees or indeed retirement you can take bigger risks with your investment funds.
On the flipside, if you will need your funds in the near or medium term you need to lower your risk exposure as you may not have enough time to make up any losses suffered by your investment portfolio.
Investing with your life goals in mind is called ‘goal-based investing’, in other words you focus on attaining specific financial goals such as saving for your children’s school fees, rather than investment goals such as maximizing returns or beating market performance.
Other risks relevant to personal investment
Adjusting a personal investment portfolio to adequately take account of all risk factors is difficult, compounded by the risk factors faced by individuals. For one, your investment horizon can be abruptly shortened due to an unforeseen event, such as a loss of employment or a medical condition. This so-called ‘horizon risk’ matters because it can force you to endure big losses on investments you were not expecting to sell.
Personal investors also face another, often ignored risk: that of ‘longevity risk’. What happens if you outlive your savings? Or indeed, if you pass away before you can fully utilize your savings, in the absence of an heir?
Getting advice on personal investment risk
It should be clear by now that the risks faced by personal investors are varied and complex. On top of that, you need to adjust your response to investment risk over time. Juggling this intricate set of rules and facts can be a challenge and expats (including international families) have additional factors that they need to take into account.
Qualified, experienced personal financial advisors should help you navigate the risky waters. Typically financial advisors will try to understand your risk profile by asking you a set of questions or having you complete a survey in order to craft a portfolio that meets your needs and goals, on a risk-adjusted basis. This objective process determines your personal tolerance to risk, mapping out an investment strategy including the assets that match your risk preference. For example, Myra Wealth utilizes Prospect Theory, a Nobel Prize-winning model of behavioral economics, to conduct an individualized risk analysis for each of their clients to set transparent goals and expectations for their investments.
As much as you should consider professional advice for investment, a basic awareness of how investment risk works can help you gauge the quality of the advice you are receiving.