It never fails—when I have new clients coming in, they say they want all of the upside but none of the downside. Basically, they want their investment cake and to eat it too. However, the truth is you can’t invest without taking some risks. You need to understand the types of risk in investing that warrant concern and the types that are best left to the experts to worry about. Let’s discuss the types of investment risk and their causes.
The risk of investments declining in value because of economic developments or other events that affect the entire market. The main types of market risk are equity risk, interest rate risk, and currency risk.
This risk of being unable to sell your investment at a fair price and get your money out when you want to. To sell the investment quickly, you may have to accept a lower price. In some cases, such as exempt market investments, it may not be possible to sell the investment at all.
The risk of loss because your money is concentrated in a particular type of investment. When you diversify your investments, you spread the risk over different types of investments, industries, and geographic locations.
The risk that the government entity or company that issued the bond will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity. Credit risk applies to debt investments such as bonds. You can evaluate credit risk by looking at the credit rating of the bond. For example, long-term Canadian government bonds have a credit rating of AAA, which indicates the lowest possible credit risk.
The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. Inflation erodes the purchasing power of money over time, meaning the same amount of money will buy fewer goods and services once inflation kicks in.
Inflation risk is particularly relevant if you own cash or debt investments like bonds. Shares offer some protection against inflation because most companies can increase the prices they charge to their customers. Share prices should, therefore, rise in line with inflation. Real estate also offers some protection because landlords can increase rents over time.
The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. This may force you to sell investments that you were expecting to hold for the long-term. If you must sell at a time when the markets are down, you may lose money.
The risk of outliving your savings—especially relevant for those already retired or nearing retirement.
The risk of loss when investing in foreign countries. When you buy foreign investments, for example, the shares of companies in emerging markets, you face risks that do not exist in Canada, for example, the risk of nationalization.
This is a risk for bond issues and refers to the possibility of a debt security being called before maturity. This typically takes place when interest rates are dropping.
The risk associated with the possibility of nationalization, unfavorable government action, or social changes resulting in a loss of value is called social or political risk.
These are just a sample of the many different risk types that arise when investing. You can experience one or multiple types at any time! Clearly, investing can be complicated. That’s why I implore you to hire a CERTIFIED FINANCIAL PLANNER™. Making that choice could help make your life financially simple. Contact us if you have questions about these or any other investment risks involved.