Investment risk can be defined as the potential that actual returns will differ from those expected. Generally speaking, the greater the variation in potential gains or losses, the greater the investment risk. Therefore, low-risk investments, such as savings and money market deposit accounts, usually mean lower expected returns than high-risk investments such as commodities and financial futures.
It is important that investors understand that the risk associated with any investment is directly related to its expected return and its expected holding period. Investors should also understand the relationship between the return they can expect on an investment and the amount of risk that they must take to earn that return. In general, investors seeking higher returns must be prepared to assume higher risks or reduced liquidity. Failure to understand this risk-return tradeoff is the primary reason many investors choose the wrong investments and face catastrophic results.
A fundamental principle of investing is that most things come at an opportunity cost. If the investor uses money or other resources in a particular way, those resources cannot be used for anything else at the same time. Every investment choice must be made at some cost. For example, if an investor uses available capital to purchase a mutual fund, that capital cannot be used at the same time to purchase commodities.
There are a number of risks that an individual must weigh when selecting an investment. The most important of these risks, that widen an investment's range of possible return, are:
- Purchasing power risk – Inflation, the general rise in prices over a period of time, tends to reduce purchasing power. As prices increase, the purchasing power of fixed amounts of principal declines. In other words, if investment doesn't grow faster than the rate of inflation, the investor is losing money. Therefore, investors must seek investments that produce a rate of return that compensates for lost purchasing power.
- Interest rate risk - These are often caused by a fluctuation in the supply of, or demand for, money. Interest rates seldom remain stationary for long periods. As they rise and fall, they affect the value of fixed value investments, such as bonds.
- Liquidity risk - Liquidity risk is the possibility that the seller will not find a ready, willing and able buyer for an asset. An individual's investment strategies should include an estimate of the time period over which the assets will be held.
- Market risk - Market risk, using the price of real estate, mutual funds and other investments, may fluctuate because of economic, social or political conditions. For example, investors who are interested in purchasing stocks in multinational corporations, such as IBM or Nestle, should carefully consider the political climate in various countries in which the corporations do business. An unstable government's civil war creates volatile investment environments.
Risk Management; How to Handle Risk?
Risk is unavoidable. By doing nothing, one has chosen a strategy; one that entails risk. By doing nothing (e.g., spending everything) opportunity cost risk is elevated. By failing to put money to work, the effects of inflation are increased. For example, if a dollar buys a certain amount of food today, but buys less 10 years from now, individuals have lost realpurchasing power if they don't act. Additionally, by spending everything, one is exposed to the risks of disability, death or excess longevity.
Just as there are many ways to define risk, there are many ways to deal effectively with
it. There are three basic methods for handling risk.
1. Avoid it. For the same reason some people don't play cards for money, others avoid various risks by choice. By choosing not to purchase stocks, the risk of losing capital if the price of stocks falls is eliminated. It is, however, impossible to avoid simultaneously all forms of risk.
2. Accept it. Before any investment is made, an individual can estimate what the risk might be in relation to the potential return.
3. Minimize it. Risk can be reduced or eliminated by transferring it to another party. Insurance, for example, is a business tool for handling risk by spreading it among a sufficiently large number of similar exposures to predict the individual chance of loss. Hedging, used by commodity futures traders, is an investment strategy to offset or minimize potential damage caused by adverse price changes. Another way to minimize or offset risk is diversification, which is the inclusion of a variety of investment products in one's portfolio.