We hear a lot about ‘risk’ and generally have an internalised idea of what it means, but in finance risk can be specific, it isn’t just about ‘losing money’ or the risk upside where you make money.
Risk comes in different forms and has different effects depending on how you are affected, we’ll take a look at a few kinds.
Investment risk is the risk that on maturity or encashment of a financial product the return is less than expected or is less then actually invested. There are several reasons why investments might not give the expected return, some of these relate to the risks below, but bear in mind there is always a ‘risk of doing nothing’ which is generally a symptom of opting for safer assets that underperform other choices.
Market / Systemic Risk
If there is a general fall in value on the stock markets, or in whatever market you invested in. We have seen many of these in prior years, gold had a huge downside risk for buyers in the late 70’s when prices collapsed in following years. Property is an excellent example for the Irish market and the anaemic performance of stocks in the last decade is also a current example.
Where there is a fall in value of a specific stock or investment, again, you need look no further than the Irish property market.
Active Investment Risk
Where the fund manager gets some investments wrong and the value drops. Even the good investors make this error, a manager can have a bumper year and then lose it all the next year, and this often happens, it is also an argument for considering indexed funds so that you don’t get this type of risk as indexed funds have often trumped managed funds in the long term, it takes a special kind of manager to make lots of money very often, which is why there is only one Warren Buffet.
Where investment is in another currency and might fall in value versus Euro. If you had invested in any market overseas in the past you would have seen that your investment might be down or up by 10% but when you turn it back into Euro it could be different depending on whether exchange rates were working for or against you. Sometimes when both are in your favour you have a much bigger gain than expected, had people piled into US equities in early 09′ they would be sitting even prettier now than otherwise expected.
Where the fund borrows to invest, the higher the gearing the higher the risk. Borrowing basically magnifies outcomes, it makes losses bigger and gains bigger, this isn’t like having a margin account per se although this can also happen with margin accounts. In simple terms borrowing to buy property is an easily understood version of this.
This happens where the investor can’t access funds to encash or can’t encash at its fair value. This is really common in the bond market and less so (but does occur) in the stock market, in particular overseas smaller markets. If there is nobody on the other side of your trade who wants what you are selling it can create ‘liquidity risk’, an asset worth €50,000 is not really worth that if you can’t sell it when you want to, illiquid assets (I’m back to referring to property again!) are therefore prone to this additional risk.
Inflation risk occurs when the value of the investment return might not match initial value in real terms.
Interest Rate Risk
This is when a general rise in interest rates will likely cause certain investments to fall, it happens in fixed income (the bond market) and can be a problem when people lock money away into products that pay below par returns, German bonds for instance have negative yields up to 2014 at present, if tomorrow there was a sharp rise in inflation you would be stuck with an investment that loses money (but is very safe) and would mean losing more to liquidate. Property again has this risk attached if you use gearing because changes in the interest rate can affect the outcomes.
Default / Credit Risk
A widely understood risk, where the financial institution gets into difficulty and might not meet its obligations. This can also happen when countries default (eg: Argentina) or any debtor doesn’t honour their line of credit.
This is where a third party bank does not return the expected money payable when due. It is also a risk that you see in over the counter financial products because there is no exchange backing the trade, for instance, futures are guaranteed as they are exchange traded, an interest rate swap with another company however, is not.
Target Return Risk:
This is where the investment product did not meet the expected return.
Hope that hels define a few aspects of risk!