You often hear the old cliche “The higher the return the higher the risk” from financial experts. That’s because no legitimate investment instrument exists without risk. There is always a risk in everything. Even the simple act of riding a bike has the risk that you might fall off, or that your pedals break. There are even more risks when it comes to investing. That is why you have to carefully choose which investment instruments you enter into and understand the underlying risks within each of them.
Here are some types of risk:
Interest Rate Risk
This refers to the risk that changes in interest rate will impact the price of bonds and stocks. If interest rates for bonds increase, the prices of bonds will go up as more people will buy them for the higher returns. Coincidentally, the prices of stocks might go down due to people selling their stocks to buy more bonds. When the opposite happens and interest rates drop, the price of bonds will also drop.
If you want to learn more on why interest rates change, click HERE.
This refers to the risk that the price of stocks you’ve purchased fall below your expected return. This could also refer to the average stock price of the market being lower than market estimates or historical figures. Don’t blindly trust financial experts who try to predict the growth of the stock market. If they could do so with certainty, they would already be the richest men alive. There will always be a risk that prices won’t rich these expert estimates.
Tax and Legal Risk
This pertains to the risk that new tax or economic laws will have an adverse effect on certain businesses. This was the case when the Philippine’s Department of Environment and Natural Resources (DENR) started cracking down on illegal mining practices. As a result, the stock prices of several mining companies plummeted, with some even closing down for good.
This pertains to risk that affects investments at a grand scale. These include wars, political unrest or natural disasters on a grand scale. They affect more than one industry and investment type. Their effects also last far longer than that of other risks.
Liquidity refers to how fast an asset can easily be sold to the market and converted to cash. Liquidity risk pertains to the risk that you won’t be able to sell your asset at once. One example would be owning a bond of a multinational company. Let’s say that you want to sell it now and not wait for it to mature due to financial difficulties. There is a risk that no one would be willing to buy it from you. As a result, you sell it for less than market value or discounted price.
This pertains to the risk that new technological advancements may turn existing businesses obsolete. It is most closely related to tech startups. However, some traditional businesses have also been hit hard by it. Several known newspapers and magazines have been shutting down over the past years due to the global acceptance of the internet. Kodak and other film companies have also suffered great financial losses due to the invention of digital cameras and DSLRs.