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Whenever investing in any asset class or investment product, there are risks that we take on for the potential to make a return. In this article, we will go over some common risks that investors take on when trading the financial markets, how to identify them, and potentially mitigate them to help you reach your financial goals.
1. Market Risk
This type of risk refers to the possibility that your investment may experience volatility, or underperform due to declines or fluctuations in the overall market rather than just your specific investment. To understand this type of risk, it is important to understand the overall market in which your investment operates and to monitor that market’s health. This includes keeping up with geopolitical factors, interest rates, and inflation to understand how they will affect your underlying investment.
2. Inflation Risk
This type of risk, sometimes known as purchasing power risk, is the chance that the rate of return that your investment yields will be outpaced by inflation, meaning that the ‘real’ or ‘inflation adjusted’ value of your investment will go down. Some types of investments are frequently used as ‘inflation hedges’, such as real estate and commodities. If inflation is a concern, you may look to diversify into these investments, adding them to your asset allocation as part of your investment strategy.
3. Currency Risk
Sometimes called foreign exchange risk, currency risk refers to the risk taken when investing in foreign assets or assets such as foreign stock markets denominated in non-local currencies. You may expose yourself to the risk that your investment may underperform or incur losses due to changes in exchange rates. One method to manage this risk is through currency hedging.
Suppose a US investor with a position in a European asset XYZ is denominated in euros (EUR). If the value of the euro (EUR) increases against the US dollar (USD), their investment in dollar terms will increase, given that the European stocks are priced in euros. Conversely, if the euro weakens against the dollar, the value of their investment in dollar terms would decrease, even if the European stocks hold their value in euro terms. To mitigate this risk, they could take a short position in EUR/USD of equal value to their investment in XYZ.
If the euro weakens against the dollar, the losses to their European stock portfolio would be offset by gains in their short EUR/USD position. In other words, they would profit from the EUR/USD position if the euro fell against the dollar, which would compensate for the reduced dollar value of their European investment. On the other hand, if the euro strengthens against the dollar, their European stock portfolio would gain in value but lose on the short EUR/USD position. Ideally, these gains and losses would offset each other, thus hedging currency risk.
4. Liquidity Risk
Liquidity risk is the risk that you will not be able to divest from a position quickly before the price changes significantly. This can happen in times of extreme economic stress or in certain assets that are less popular and have less liquidity as a result. One way to avoid this risk is to try to avoid assets that have low liquidity or use financial contracts, where you trust that your counterparty will be able to fulfil their financial obligations to you.
5. Concentration Risk
Concentration risk is the risk associated with having a large part of your investment portfolio concentrated in highly correlated assets such as ones in the same industry or region. The standard way to mitigate this risk is through diversification, or making sure to invest in a wide variety of different assets. A common and easy way to do this is through instruments like Indices or Exchange-Traded Funds (ETFs), which are instruments that are already diversified and may give you exposure to hundreds of different assets through a single instrument.
6. Counterparty Risk
Counterparty risk, sometimes called ‘default risk’ or ‘credit risk’, is observed when trading in financial contracts. It refers to the risk that the party that you have entered into the contract with will not be able to meet their financial obligations or they ‘default’ on the obligation. To manage counterparty risk, an investor should do their due diligence and assess the creditworthiness of their counterparty before they enter a financial contract.
7. Specific Risk
Specific risk is associated with a particular individual investment within a portfolio. This type of risk arises due to factors unique to the underlying asset in which you are invested. This type of risk can only really be managed through a good understanding of the asset concerning your underlying asset.
When trading, it is important to understand and manage the various types of risks that come with your investments and make sure that the degree of risk you take on is consistent with your investment goals. By maintaining a diversified portfolio, doing due diligence, and monitoring market conditions or hedging, you can help mitigate these risks and make informed investment decisions. Always stay informed and make decisions that align with your personal investment goals and risk tolerance.
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