Four Types of Investment Risk

Natalie LeBlanc |
Categories

When we think about risk, lots of potential situations could come to mind. Repairing a roof without a safety hardness is risky. Getting on the highway every morning is risky. Investing is risky. The degree of risk in each situation, without exception, always depends on multiple factors. Are you wearing cleated boots? Is it snowing? Has the CEO of a multi-million-dollar tech company stepped down? The risk in any of these given situations can be mitigated with proper planning, preparation, and knowledge.

In the case of investing, there are four different types of risk that we can consider when assessing how risky”our investment choices are. Let’s preface, however, by reminding you that there is always an inherent risk in investing in mutual funds. No return is guaranteed, but we can arm ourselves with the proper planning to minimize our risk and maximize our potential reward.

Diversifiable Risks

The first two types of risk are diversifiable risks. These affect various kinds of assets in different ways. In other words, with proper asset diversification, these risks are minimized.

  1. Growth risk is generally the risk that is top of mind to beginner investors. Will the value of my investments increase or decrease by the time I want to retire? Will the stock market’s valuation increase or decrease over the next few years? For example, the price of a stock of a publicly-traded technology company will react differently to general economic growth than the stock of a transport company specialized in bus transportation. The old adage of not keeping all your eggs in one basket helps mitigate a portion of this risk. 
  2. Inflation risk. Some investments are affected most by expected inflation like bonds, gold, and other commodities. When inflation is perceived to be high, investors are more likely to want to spend now, while the cost of goods is low. This means that the value of bonds decreases while commodities increase, affecting the returns of your portfolio.

By not investing all your assets in gold or one stock, you minimize the growth and inflation risk you will face. It is important to hold a well-diversified portfolio to manage these risks.

Undiversifiable Risk 

The next two types of risk affect given assets in the same way. Making a “better” investment choice doesn’t help in these cases. They represent the inherent risk of stock investing that cannot be diversified away:

  1. Policy risk: Interest rates are one example of how government-based policies affect your investment values. When cash earns just as much interest as you gain in a stock, most investors would rather take the less-risky cash option, right? When interest rates go up, fewer people choose stocks over cash investment, lowering stock values across the board.
  2. Sentiment risk: The driver of stock markets, either up or down, is investor sentiment. Prices are derived from what analysts and managers think about the company in question. The collective opinions on an investment choice can be wrong, presenting sentiment risk.

It is unfortunate but true that we can’t anticipate every stock market drop, and those drops can affect your portfolio. Diversification can minimize your risk but there is always a certain degree of risk we accept when investing in mutual funds. For more information on the assets your portfolio include, and how to mitigate risks in your portfolio, call your advisor.