Whenever you invest in a business, you are in the shade of different types of risk. Here is the discussion about how these risks affect the return on investment.
Types of Investment Risk
The risk causes decline in value due to economic development or other events and that affect the whole market. The main market risks are equity, interest rate, and currency risk.
- Equity Risk: The risk applied to investments in share. The market prices of a share vary every second, depending on the demand and supply. This is the risk of loss due to drop in the price of shares.
- Currency Risk: It applies to foreign investments. This is the risk that reduces money due to exchange rate movement. For example, if U.S dollar becomes of low value as compared with the Canadian dollar, the U.S stock will have less value in the Canadian dollar.
- Interest Rate Risk: The risk applies to the debt investment, i.e. bonds. The risk causes the losing money due to change in the interest rate. If the rate increases, the value of bonds will drop.
This is the risk of being not able to sell the investment at fair prices and get your money back whenever you want. For selling investment, you need to accept low prices. In some cases, like exempt market investment, selling of investment is not possible.
This is the risk of loss because your money is in one investment or any type of investment. If you diversify your investment, the risk prevails over other investments, industries, as well as geographic locations.
The risk arises when a company or any government entity issuing bond run into financial difficulties and then become unable to pay the interest. The risk applies to debt investment. The credit risk can be evaluated by considering the credit rating of any bond. For example, the long term Canadian bonds have a rating of AAA, which means that the credit risk is at its lowest level.
This is the risk of loss from principla of reinvesting or income at low interest rate. Suppose, you purchase a bond by paying 5%. If interest rate drops, the reinvestment risk will affect and you have to reinvest the payments at 4%. The risk alos applies if bond matures and you are required to reinvest the principal at below 5%.
A risk of loss in the purchasing power because the investment value does not come up with inflation. The inflation erodes the purchasing power over time- the same money will buy a few goods or services. The risk is usually relevant if you own a cash or debt investment like bonds. Some shares offer protection against inflation because many companies can increase the cost for the customers. Real estate alos offer protection because some landlords can increase rents.
The risk may arise due to an unforeseen event. Example is that you loss your job. Now you are forced to sell the investments you hold for the future. If markets are down at that time, you may loss your money.
This is associated with outliving your savings. This is particularly relevant to the people who are retired or ging to be retired.
Foreign Investment Risk
This is associated with investments in foreign countries. For example, the risk of nationalization.