Understanding Investment Risks

In simple terms, investment risk is the possibility that the actual return on an investment might differ from the expected return. This variance could result in an unanticipated financial loss or a smaller gain. However, risk is not inherently negative; rather, it’s an essential element that, when managed correctly, can be a part of aiming your portfolio for growth.

Every investing opportunity is unique and offers different potentials for risk and rewards. Understanding the relationship between this risk and reward is fundamental to building out your investment plan. Depending on the asset class and opportunity, investments that carry higher risk can carry the potential for higher returns. Those with lower risk might offer more stability but can also yield lower returns. Understanding this balance is important in designing a portfolio aligned with a client’s financial goals, timeline, and risk tolerance.

Investment risk can be broken down into several types, each affecting a portfolio in different ways:

This is the risk of loss arising from a borrower’s failure to repay a loan or meet contractual obligations. It primarily affects bond investors who rely on companies or governments to make good on their debt payments.

Liquidity risk occurs when it’s difficult to buy or sell an asset quickly without significantly affecting its price. Investments in real estate, private equity, and some stocks may come with higher liquidity risk.

This risk impacts bonds and other fixed-income securities. When interest rates rise, the value of existing bonds might decrease, as newer bonds might offer higher returns.

Inflation risk refers to the erosion of purchasing power over time. If the rate of return on an investment is lower than inflation, the real value of the returns can become diminished.

These are risks unique to a particular company or industry, such as operational issues, regulatory changes, or competitive pressures. Diversifying across multiple sectors and asset classes can help reduce specific risk.

Wealth management professionals might use a variety of tools and methods to evaluate investment risk and construct portfolios that align with clients’ financial aspirations. Key practices include:

Through questionnaires and in-depth conversations, advisors can gauge each client’s comfort with risk. This is influenced by factors like investment goals, age, income, and time horizon.

A well-diversified asset allocation strategy can help spread risk out across different asset classes, such as stocks, bonds, real estate, and cash. Each class can respond differently to market events, working to balance the portfolio.

Markets are dynamic, and a portfolio that suits a client today may not align with their goals in the future. Wealth managers can help by regularly reviewing and rebalancing portfolios to adjust for shifts in market conditions or personal circumstances.

Risk is an important factor to consider when investing. Without risk, portfolios would consist mainly of low-yield assets that may not keep up with inflation or achieve desired financial outcomes. Taking calculated risks can help wealth managers seek higher returns that are balanced against a client’s objectives and timeline.

For example, younger investors with a longer time horizon might be able to tolerate higher levels of risk, enabling them to allocate more heavily toward equities, which have the potential for greater growth. On the other hand, retirees may prefer lower-risk investments that preserve capital and generate stable income.

While risk is an inherited part of investing, it is crucial to understand your personal risk tolerance and identifying how you can mitigate risk to position your portfolio for growth.

Investment risk is an unavoidable aspect of investing, but it doesn’t have to be intimidating. When approached with a clear understanding and informed strategies, risk can become a tool for building your portfolio.

If you’d like to understand how we can help manage investment risk to work towards your financial objectives, reach out to us today. Our team of dedicated wealth management professionals is here to provide you with the expertise, insights, and support you need to navigate the complex world of investing.

Sources:

• Investopedia. "Systematic Risk: Definition and Examples". (Aug 15, 2024). Retrieved from https://www.investopedia.com/terms/s/systematicrisk.asp#:~:text=stock%20or%20industry.-,Systematic%20risk%20refers%20to%20the%20risk%20inherent%20to%20the%20entire,a%20particular%20stock%20or%20industry.
• Merrill. "Understanding bonds and their risks". (2024). Retrieved from https://www.merrilledge.com/article/understanding-bonds-and-their-risks.