Investment risk

Investment risk

On ground of assurance of the return, there are two kinds of Investments - Riskless and Risky. Riskless investments are guaranteed, but since the value of a guarantee is only as good as the guarantor, those backed by the full faith and confidence of a large stable government are the only ones considered "riskless." Even in that case the risk of devaluation of the currency (inflation) is a form of risk appropriately called "inflation risk." Therefore no venture can be said to be by definition "risk free" - merely very close to it where the guarantor is a stable government.

Types of risk

Depending on the nature of the investment, the type of investment risk will vary.

A common concern with any investment is that you may lose the money you invest - your capital. This risk is therefore often referred to as "capital risk."

If the assets you invest in are held in another currency there is a risk that currency movements alone may affect the value. This is referred to as "currency risk."

Many forms of investment may not be readily salable on the open market (e.g. commercial property) or the market has a small capacity and may therefore take time to sell. Assets that are easily sold are termed "liquid"; therefore this type of risk is termed "liquidity risk."

The risk that there may be a disruption in the internal financial affairs of the investment, thereby causing a loss of value, is called "financial risk." A prime example of that form of risk was experienced by the investors in Enron, or one of the "dot-com" stocks that really never did have a profitable financial footing. Many of the employees of Enron experienced both liquidity and financial risk as the price decline in the stock of that company occurred just as there was a "freeze" on stock liquidation in their retirement plans.

Perhaps the most familiar but often least understood form of investment risk is "market risk." In a highly liquid market like the collective stock exchanges in the United States and across the developed world, the price of securities is set by the forces of supply and demand. If there is a high demand for a given issue of stock, or a given bond, the price will rise as each purchaser is willing to pay more for the security than the last one. The reverse of that occurs when the sellers want to rid themselves of an issue more than the buyers want to buy it. Each seller is willing to receive less than the last one and the market price, or valuation, declines.

The same form of risks apply to a house, an issue of stock, a mutual fund, or a bond. Some forms of investment risk can be insured against. For example, the risk that an investment rental property might burn down, or the custodian of your stock and bond investments might go out of business. Most of the forms of risk that we concern ourselves with, financial risk, market risk, and even inflation risk, can at least partially be moderated by forms of "diversification".

For example, a person investing $10,000.00 for one year may desire a gain of $1,000.00, or a 10% return, providing a total investment of $11,000 after one year. In reality, investing, as opposed to saving, rarely provides such a neat solution. For example, the average annual compound return of the broad American stock market over the time period from 1926 to 2006 was just over 10% per year. During that eighty year period though, there were more than a few times when massive declines in market value were experienced by investors in that same stock market. From early in the year 2000 through the fall of the year 2002 for example, the broad measures of market valuation, such as the S&P 500 Stock Index fell over 50%. For an investor in 2006 to have seen that average compounded 10% return in the S&P 500 Index, he or she would have had to invest in 1994. The 15% average annual rate or return was there, it just took twelve years of patient waiting to see it.

At least the investor in a S&P 500 Index Fund has some degree of assurance that if he or she waits long enough a positive return is very likely to occur. The investor who elected to invest everything in Enron is left only with the assurance that the investment was a complete loss. Enron, as a stock issue, was a part of the S&P 500, and its loss did have a temporary effect on that index, but the effect was not permanent or, in the long run, of any significance. That is the value of diversification. Further diversification away from the large capitalization stocks that make up the S&P 500 Index has historically tended to further reduce market and financial risk.

A science has evolved around managing market and financial risk under the general title of Modern portfolio theory initiated by Dr. Harry Markowitz in 1952 with his seminal article, "Portfolio Selection."

ee also

* Credit risk
* Financial risk
* Insurance industry
* Interest rate risk
* Legal risk
* Liquidity risk
* Market risk
* Optimism bias
* Reference class forecasting
* Reinvestment risk
* Risk premium
* Risk attitude

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