The 8 types of Investment Risk

investment risk

Investing is all about risk and reward. In endeavoring to build our wealth and gain choice in life, we take on risk with the expectation that we will be rewarded for taking on that degree of uncertainty.

The Oxford Dictionary defines risk as the “possibility of something bad happening at some time in the future”. As investors that typically means a loss of our capital, either partially or in full.

We think a lot about the potential rewards and the long-term outcomes that derive from the gains made by our investments, but this week I wanted to spend a little bit of time digging into some detail on the risk side of the equation. I’ve identified 8 different types of risk that are relevant for us investors.

To be fair this list probably has more of a bias to stock market investors. I haven’t included things like credit risk which would be relevant for bond investors, or risks that are unique to property investment.

I’m hoping that as I go through these eight types of investment risk you mentally tick them off against your portfolio and reflect on whether you were comfortable with the level of risk that you are sitting at.

Let’s dive in.

1.    Liquidity Risk

First cab off the rank is liquidity risk. I’ve started here because this is one sometimes underappreciated, yet extremely important. Liquidity risk refers to the ability for you to liquidate your investments and turn them into cash.

Shares for instance typically take three days between when you enter the instructions to sell, and you receive your money in the bank. Residential property is usually 30 to 90 days between signing a sale contract and receiving your cash. In reality it’s actually longer than that because it takes some time to market the property before a contract of sale is signed. Commercial property takes even longer to liquidate because there are fewer potential buyers.

Ranking these three investments then we can say that shares have a lower level of liquidity risk than residential property, and residential property has a lower level of liquidity risk than commercial property.

2.    Market Risk

Market risk is probably the one most of us think about when investing, even though we may not apply this label. Market risk refers to the volatility in the price seen in your particular investment. We know that markets have periods of optimism and pessimism, with prices rising or falling with little reference to the underlying businesses that the shares represent.

Market risk can be thought of as volatility. Indeed in most academic literature looking at stock market investment, references to risk are entirely addressing volatility. Volatility, and therefore market risk, is a problem if you are a short term investor, or have a very inflexible time frame around which you need to sell holdings.

Market risk can be managed through the inverse of these two positions. By holding investments long term, short term volatility is of no concern. The historical evidence demonstrating that stock market investments will rise over the long term is pretty compelling, and validated by the fact that profitable businesses will reinvest at least part of those profits back in the business, building on the asset base and therefore value of your underlying investment.

Market risk is also managed by having flexibility around the timing of your eventual exit. If you require your proceeds on a particular date, and delay the sale until the last possible moment, then you’re very much at the mercy of the market on that day.

3.    Exchange rate risk

Here at Guidance we tend to have a bias towards US shares in our client portfolios on the basis that historically they’ve delivered a higher rate of growth. The challenge however with this approach is that sometimes, whilst the market might move in the direction that you would hope, the exchange rate moves against you, either partially or wholly offsetting the market gains.

Essentially, when the Australian dollar rises in value relative to the US dollar, that is bad for the value of international shares that you already own. If you’re a new investor though, looking to get money into international markets, then a higher dollar is in your favour.

Dollar cost averaging and investing for the long term is the primary way this risk can be managed. Sometimes the exchange rate works against you, but other times it works for you, and in my experience, given long enough, the two even each other out.

You can get hedged investment options which take out insurance to remove exchange rate risk. You could construct your portfolio to have a portion of your international equities hold hedging in place, to limit the impact of exchange rate risk. Just be aware that this hedging is not free, the cost means that your total return is reduced.

4.    Concentration risk

We typically talk about investment portfolios. Portfolios are a mix of different investments. We create this mix as a way to reduce risk.

Any single investment could have a broad range of outcomes, from tremendous success, to going broke. However a portfolio of 20 different investments has a far narrower range of potential outcomes. The likelihood of all 20 investments going to zero is insignificant provided those 20 holdings aren’t all in a single highly speculative sector.

This process of diversifying through creating investment portfolios exists to address our 4th type of investment risk – concentration risk.

We most typically see examples of people with high levels of concentration risk where they’ve worked for an employer and received a significant amount of shares (RSU’s or options) as part of their compensation package, such that a large proportion of their wealth is held in the shares of that single business.

Concentration risk also crops up for property investors where all their investment wealth might be in a single property, reliant on a single tenant, and hoping that that property and suburb experiences meaningful capital growth.

Diversification is the antidote to concentration risk.

5.    Inflation risk

Inflation risk is something that’s been a live issue over the past couple of years. This is the risk that the purchasing power of your savings diminish over time.

Bank investments are where we most commonly see inflation risk play out. Imagine you are lucky enough to receive a $1 million inheritance from some distant relative that you’ve never heard of. At the time of receiving the inheritance you contemplate purchasing a house near the beach which has a price point of exactly $1,000,000. You decide against it though, and instead put the money in the bank, comforted by the fact that it is safe and secure.

10 years later your mind returns to buying a beach house. You check on your inheritance, and are pleased to see that courtesy of the interest earned your balance has grown to now be $1.2million. You head down to the beachside real estate agent to see what’s available, only to learn that the property you could have bought 10 years ago recently sold for $2,000,000. What had been affordable, is no longer affordable. This is inflation risk.

6.    Failure risk

Most first time share investors perceive that their biggest risk is that the stock that they buy into will go to zero.

Businesses do fail. It’s part of the capitalist system. Usually, by the time a business is big enough to warrant a share market listing, it has a strong and sustainable operation. But sometimes the market environment changes, or management makes a bad call, and the business doesn’t survive.

Babcock and Brown was once an investment bank trying to be the next Macquarie, until the GFC brought it unstuck. It’s share price reached $34.16 in July 2007. In January 2009 it was delisted. Failures, whilst very rare, do happen.

Fortunately, the solution to failure risk is fairly simple. Diversification.

7.    Time horizon risk

Sometimes life doesn’t go to plan. Our 7th risk, time horizon risk, arises when you enter an investment that’s expected to be retained for a particular time frame, but then something changes and you need to exit early.

A common instance of time horizon risk cropping up is as the result of a divorce. A couple buys an investment property with the expectation that it will be retained for 10+ years, making the upfront transaction costs acceptable. Sadly, 2 years later they decide to divorce and in order to get the settlement to work, the property needs to be sold. After such a short period of ownership, it’s quite possible that the sale price achieved does not recoup all the initial transaction costs, and so the couple makes a loss on this investment. This loss has come about because the investment time horizon was unexpectedly shortened.

8.    Longevity risk

Our final form of risk is longevity risk, something that I’m talking to clients about regularly.

You’ve probably heard me speak before about the fact that a lot of the work we do for our clients is financial modelling and scenario analysis. The purpose of this work is to ensure our clients are clear on the likely long-term outlook, so that they can make decisions today that they won’t regret in the future.

Just this week I ran some numbers for a client who would like to do a big European holiday with her sister later in the year. She wanted to be sure that if she spent the money on this trip, it wouldn’t mean that she ran out of funds later in life. We were able to run the projections and give her the confidence that this trip was affordable. Without this work, she may have forgone the trip, only to then find in her 90s that she had more money than she needed, a significant waste of potential happiness.

Longevity risk might also crop up where someone is trying to understand whether they can afford to retire. We might run projections and show that were they to retire next month, we would expect their savings to run out in their early 80s. The longevity risk therefore is that they live beyond their early 80s, and no longer have savings to support themselves. In such circumstances longevity risk might be addressed by them working a little longer, investing a little more aggressively to improve earnings, or reducing their retirement living costs.

I often find that longevity risk is the risk that is frequently overlooked by those with a conservative mindset who are planning their retirement. Some people feel that in retirement they need to invest very conservatively. They want stability in their wealth. Whilst this is understandable, the unintended consequence of taking this stance is that lower returns will mean they will burn through their savings quicker than would have otherwise been the case, increasing their longevity risk – that chance that they will live longer than their savings.

Well there you have my 8 types of investment risk. To recap, they are:

  1. Liquidity risk
  2. Market risk
  3. Exchange rate risk
  4. Concentration risk
  5. Inflation risk
  6. Failure risk
  7. Time horizon risk
  8. Longevity risk

I hope they help you think through your investment strategy to make it as robust and fit for purpose as possible.