As an investor, you will encounter many different kinds of risk that may affect your investments. These risks include interest rate risk, market risk, liquidity risk, and inflation risk, amongst others.
These kinds of systematic risks (un-diversifiable risks) can significantly affect your portfolio’s value in ways that may be unrelated to how the stocks or bonds in which you have invested are performing.
In addition to systematic risks, there are behavioral risks that are driven by your own biases. In other words, an important risk as an investor… is you. Let’s tackle each of these one at a time.
Interest Rate Risk
Interest rate risk refers to the manner in which changes in the base cost of borrowing money affects the expected return from different kinds of securities.
The Federal Reserve sets the short-term interest rate level at which borrowing occurs, while longer-term interest rates will move on their own based on economic conditions.
When interest rates rise, the price of bonds decreases. In contrast, when interest rates decrease, the price of bonds increases. However, the relationship between interest rates and stocks is not as clear-cut as we discussed in this blog.
Interest rates can significantly impact an investment portfolio. An investor can hedge against interest rate risk by having a portion of their portfolio in cash, or short-term bonds, which adjust to different interest rates environments.
Trends in a specific asset market can create a tide that pushes the price of securities up or down, despite the individual security fundamentals. This is known as market risk.
An investor can account for market risk by diversifying into different sectors that either move in opposite direction to their current assets or that have no direct relationship whatsoever.
For example, an investor wishing to hedge against market risk in stocks may decide to own bonds and real estate.
Liquidity risk relates to the ease with which you can buy and sell securities.
While many large-cap stocks are extremely liquid i.e. easily converted to cash, as there are many buyers and sellers on a daily basis, securities in smaller companies sometimes have a significant difference between the bid and the ask prices (the spread). This means that if you suddenly decide to sell your securities, it may not be as quick and easy.
For certain types of assets, liquidity risk is more common and an important concern. For example, bonds and derivatives often have significant liquidity risk. Due to their less-frequent trading, their bid-ask spread at any one time might be quite significant, meaning that selling a bond is often not as easy as selling a stock.
If you are interested in securities that face significant liquidity risk, you may need to modify your investment strategy to account for this. One hedging strategy is to enter or exit positions in securities over a longer time frame rather than using immediate market orders.
An increase in inflation can easily make investment returns less beneficial than they might otherwise seem. Bonds and cash are particularly susceptible to inflation risk, while stocks generally rise along with inflation.
Similarly, deflation can push stock prices down significantly as earnings and cash decrease in value. Bonds benefit significantly from deflation, as the interest rate is suddenly more valuable.
You can understand all of the risks discussed in this piece yet still be exposed to the biggest risk of all. Yourself. We [humans] have certain behavioral aspects coded into our DNA that are hard to overcome. We have anchoring, confirmation bias, insight bias, disposition effect biases. among many others. All of them can significantly hurt your chances of having a successful investment strategy as you over- or under-react to changes in the market.
How To Protect Yourself Against Risk
Each of these risks affects different asset classes in different ways. By ensuring that you have a variety of asset classes i.e. diversify your portfolio, you will ensure that you don’t overexpose yourself to one particular type of risk.
When assessing your portfolio risk, you will need to assess your risk capacity, your risk tolerance, and your behavioral biases.
Featured image source: Inc.com.