It’s been a volatile time in global investment markets with shares and other assets being knocked about, the fallout of Brexit, and fresh record-breaking interest rate lows. At times like these, it’s little wonder that more cautious investors have a long list of questions about risk levels and the security of their financial future .
Understanding all of these risks – how they work and their potential impact – will help you assess your own attitude to risk, and ensure you begin investing with your eyes open.
Risk vs volatility
Investing is an inherently risky business, but perhaps not in the way you think. While it’s common to hear people talk about volatility as a byword for risk, they are not the same thing. In investment markets, volatility refers to daily price fluctuations. Risk, on the other hand, is the possibility that an investment will provide a lower return than expected over your time horizon or even a permanent loss. Short-term volatility is only a risk if you need to sell investments after a big price fall. The longer your time horizon, the less important volatility becomes.
Here is a rundown of some of the main types of risk:
General market risk
Market risk is the possibility that an investment will depreciate in value due to market fluctuations. An example of this would be, if you buy shares in Company X at $50 per share today, the value of those shares could drop to $40 or $30 per share over time due to caused by factors such as, changing economic conditions, market sentiment, local and international political events and even environmental issues.
Economic risk is the chance that macroeconomic conditions like exchange rates, government regulation, or political stability will affect an investment, usually one in a foreign country. This refers to the possibility of an economic shock or crisis that will cause panic selling, such as a debt crisis or a credit squeeze.
Interest rate risk
Changes in interest rates can have a direct or indirect impact on the investment value and/or returns of all types of assets. A good example of this, are bonds and other interest-bearing assets that offer a rate of return, which is usually based on the current official interest rate. Since official interest rates rise and fall, there’s a chance that these kinds of investments may generate a lower than expected return. Interest rates may also affect a company’s cost of borrowings.
With the Reserve Bank of Australia dropping the cash rate to a fresh record-breaking low of 1.5% on Tuesday, August 2, combined with the 2015 Australian government Intergenerational report, questions are already arising around what low-interest rates really mean for retirees and savers.
Exchange rate risk
Exchange rate risk (also known as FX risk, foreign exchange risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company. Exchange rates add another layer of risk when you invest in international markets or local shares with overseas operations.
Country risk is a collection of risks associated with investing in a foreign country. These risks include political risk, exchange rate risk, economic risk, sovereign risk and transfer risk, which is the risk of capital being locked up or frozen by government action. Country risk varies from one country to the next.
This applies to particular sectors of a market or economy. For example, the spread of the internet is disrupting the business model of companies in the media sector, while low commodity prices have hit companies in the resources sector.
Risk that affects a very small number of assets. Specific risk, as its name would imply, relates to risks that are very specific to a company or small group of companies. This type of risk would be the opposite of general market risk.
That may sound like a lot of risks, but without accepting some degree of risk you are unlikely to earn the returns you need to keep ahead of inflation and achieve your financial goals.
The amount of risk you accept depends on your personal tolerance for risk, your investment goals, and your time horizon. You can’t banish risk entirely but the good news is that most risks can be reduced or managed with some simple strategies. If you would like to discuss your risk tolerance in the context of your investment portfolio, don’t hesitate to call.
This article is for general information purposes only. It has been prepared without considering your objectives, financial situation or needs. You should, before acting on the information, consider its appropriateness to your circumstances.
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