Consistent investing can be a powerful strategy for building wealth over time. However, it is important to note that potential rewards do come with inherent risks.
Whether you’re a first-time investor or an experienced one, understanding the different types of investment risks can empower you to manage your portfolio more effectively and navigate your path to financial success. Here are some common types of investment risks that you need to be aware of before investing in stocks, bonds, or unit trusts.
Market risk
Market risk is the possibility of losing money from overall changes in financial markets. This often happens due to factors such as changes in interest rates, negative economic growth or geopolitical events. When this happens, you will find the value of your investments falling significantly, even if the companies you invest in are strong and have been performing well.
The Global Financial Crisis in 2008 is an example of market risk affecting stock, bonds and currency markets simultaneously across the world. During the crisis, investors found themselves losing money even though they had diversified investments.
Tips:
- When market risk happens, monitor economic news for information on the cause and severity of the sell-off. Knowing the facts allows you to make informed decisions, for example, if you should wait out the sell-off, invest more in quality companies at a lower price or cut losses in weaker investments.
- This allows you to adjust your investment portfolio for the longer-term based on changes in economic trends, interest rates or other factors. More experienced investors may consider hedging investments from large losses using instruments like options.
- Ensure that you have sufficient emergency funds for situations where you may not be able to easily sell certain investments if you suddenly need cash for unforeseen circumstances.
Liquidity risk
Liquidity risk is the possibility of being unable to sell an investment when you want to and at a price you want. This applies to investments that cannot be easily converted to cash, like property or certain bonds, or when there are more sellers than buyers in the market.
For example, selling an investment property such as an apartment comes with a higher liquidity risk as compared to investing in quality companies or unit trusts as it is more unlikely for you to find a buyer and be paid at a high value and/or in full within the same day of selling that property.
Tips:
- Before making any investment, find out how easily you can sell it when you want to.
- If you have a large amount invested in less liquid investments, balance your portfolio with more liquid investments that you can sell more easily.
- Keep an emergency fund of three to six months’ worth of expenses so that you do not have to sell investments in a hurry and potentially at a loss should you suddenly need cash.
Inflation risk
Inflation risk is the possibility of inflation eroding the value of your money over time. This usually applies to investments that pay a fixed rate of return, such as bonds. If inflation is higher than the returns, your money’s purchasing power decreases. For example, if a bond pays a fixed coupon rate of 3% and inflation rises to 5%, your real return upon adjustment for inflation, would be negative. Should this persist, you’re losing money in terms of what you can buy, making it harder to maintain your financial goals. This can impact financial planning for the long term, like retirement planning.
Tips:
- To stay ahead of inflation, consider investing in a diversified basket of bonds, stocks, unit trusts and commodities which can appreciate along with inflation.
- Some exposure in property and REITs can also help you manage inflation risk.
Interest rate risk
Interest rate risk is the possibility of losses from interest rate movements. This usually applies to bond investing. When interest rates rise, bond prices fall because new bonds may be issued with higher coupon rates, making older bonds with lower rates less attractive.
Tips:
- Keep abreast of central bank policies and economic conditions that could signal changes in interest rates. When interest rates are high, consider investing in short-term bonds which are less sensitive to interest rate risk compared to long-term bonds.
- If you hold bonds, you can manage interest rate risk by investing in a mixture of short-term and long-term bonds of different maturities.
- Consider diversifying with other types of investments less sensitive to interest rate changes like stocks.
Currency risk
Currency risk is relevant for investors holding assets in foreign currencies or have investments in international markets. This occurs when the value of your investments is affected by changes in the currency exchange rates. Currency exposure can have both positive and negative effects, depending on the direction of the change. For example, if you invest in US stocks and the USD weakens against your home currency, SGD, your investment may fall in value even if stock prices stay the same. Conversely, should USD strengthen against SGD, your investment in US stocks will appreciate without stock prices going up.
Tips:
- Spreading your investments across different currencies can help you better manage fluctuations across different exchange rates.
- More experienced investors can hedge against currency risk with instruments like currency futures or options to protect against currency movements that are against you.
Political risk
Political risk is the possibility of losses on your investments due to political changes in the country, or instability in a country or region. For example, investing in a country with an unstable government or civil unrest could lead to sudden regulatory or policy changes, that could affect the liquidity and profitability of your investments.
Tip:
- Stay informed of political changes in countries where you invest.
Credit risk
Credit risk is the possibility of a borrower failing to repay principal or pay interest on a loan. When a company goes bankrupt, it may not be able to repay bondholders principal or continue paying interest. This results in investors losing money when investing in bonds.
Tips:
- Before investing in bonds, check how bond issuers are rated by credit rating agencies like Moody's or Standard and Poor's (S&P). Typically, bonds issued by companies or governments with higher ratings are considered safer but offer lower bond returns. Likewise, bonds offering higher returns may be issued by companies or governments with lower ratings.
- To lower credit risk, spread your bond investments over different bond issuers. This way, any company defaulting on a bond does not affect interest or principal of your entire bond portfolio.
- As the minimum investment amount for corporate bonds is usually large, consider investing in diversified bond funds that invest in baskets of different bonds as well.
Five ways to manage investment risks
- Know your risk appetite
Knowing how much risk you are able and willing to take is the first step to managing investment risk. Risk profiling considers various factors such as age, income, financial goals, and investment time horizon.
It is important to note that your risk appetite may evolve over time, or as you transit through different life stages, so you may need to take a risk profile assessment periodically to ensure that your investment strategy is aligned with your goals and circumstances.
- Asset allocation
Asset allocation involves investing across various asset classes, such as stocks, bonds, commodities and property to achieve different risk-return trade-offs, depending on your financial goals.
For example, a young person with a higher risk appetite and longer investment horizon may allocate more towards higher risk investments like stocks to build wealth over the long term. On the other hand, an individual approaching retirement may allocate more in bonds for regular income.
- Diversification
Spread your investments across various asset classes, regions and industries that do not always move in the same direction. When one asset class or sector experiences a decline, others might perform better, balancing out your overall investment returns over time.
- Dollar-cost average
Dollar-cost averaging is investing a fixed amount of money at regular intervals, regardless of market conditions. This disciplined approach allows you to potentially lower the average cost of investments over time.
It also takes emotion out of decision-making to avoid the pitfalls of market timing, which is especially important when adverse news affects market performance.
- Portfolio review
Review your investments periodically to ensure they remain aligned with your risk appetite and financials goals. Regular reviews also allow you to make necessary adjustments to your investments based on changes in economic trends, interest rates or other market conditions.
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