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The potential for loss. Usually, but not always, higher risk assets can have the potential for higher returns.
Risk, in the context of finance and investing, refers to the potential for financial loss. There are a load of risks to be aware of, and some of them are more niche than others. For example, there’s market risk, credit risk, and currency risk – to name a few.
The key thing to keep in mind when you’re investing, is that different assets will have different risks – which implies different likelihoods of losing money.
As mentioned above, there are a few different types of financial risk to be aware of. Depending on what you’re investing in, not all of these different types of risk will affect you.
Market risk: market risk, also known as undiversified risk, relates to the potential for losses as markets fluctuate. It includes risks associated with changes in asset prices, interest rates, and exchange rates. A well-diversified investment portfolio is the best way to combat market risk, as it spreads your risk across multiple markets.
Some assets are more susceptible to market risk than others. For example, stock prices can change quickly following good or bad company news. Other assets, like bonds or cash, are less susceptible to this type of risk – but they’re more susceptible to other forms of risk, like credit risk. That’s why a diversified investment portfolio is essential to help mitigate the effects of risk.
Credit risk: credit risk, sometimes called default risk, is the risk that a borrower will fail to make interest payments, or repay the principal amount. This risk can affect bonds – where the borrower is a government or corporation – but for assets like government bonds, credit risk is usually very low.
Currency risk: currency risk – also known as foreign exchange risk – arises when investors hold assets in foreign currencies. Fluctuations in exchange rates can impact the value of these assets, leading to gains or losses when the foreign currency is converted into the home currency.
Interest rate risk: interest rate risk is the risk that changes in interest rates can impact the value of fixed-income investments, like bonds. Rising interest rates can cause bond prices to fall, while falling interest rates can lead to higher bond prices.
Liquidity risk: liquidity risk arises when an investor finds it difficult to buy or sell a financial asset. It can lead to losses if an investor is forced to sell an asset at a less favourable price due to a lack of buyers.
Market sentiment risk: market sentiment, driven by factors like fear, greed, and investor psychology, can lead to market volatility and sudden price movements. This risk can affect investors’ decisions, as they might act less rationally and be more prone to act on impulse during market declines.
Country or political risk: this risk is associated with events or changes in a particular country’s political and economic environment that can adversely affect investments or operations. These events may include changes in government policies, political instability, or regulatory changes. Politically unstable regions are often more risky to invest in compared to politically stable ones.
Effective risk management involves identifying, analysing, and mitigating these and other types of financial risks. Diversification is one of the most effective ways to manage financial risk – as while one area of your portfolio might be affected by a certain type of risk, another area won’t be.
All investing should be long term (min. 5 years). The value of your investments can go up and down, and you may get back less than you invest.
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All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest.