When you hear the word ‘risk’ the first thing that springs to mind is usually your investments losing value. In reality, it’s far more nuanced than that. In this series of Learn articles, we’ll introduce you to the main risks you’re exposed to as an investor.
In investing, risk doesn’t just mean losing cash in absolute terms. For example, leaving your money in a savings account isn’t, at least at face value, risky. But, what about the returns you might be missing out on if you had invested it elsewhere? That’s also a risk.
Risk doesn’t necessarily have to be a bad word. Backing technology start-ups is inherently risky, but some of the world’s most respected investors do this habitually. Why? Because taking on more risk often comes with the potential to generate more returns. Think about it as being rewarded for putting up with uncertainty.
You shouldn’t, however, take on risk simply for the sake of it. There needs to be a future benefit that makes that risk worthwhile.
Would you buy a used car that’s prone to breaking down if you could buy a new, more-reliable model for the same price? You’d likely go with the safer option. If, however, you thought you could restore the used vehicle and sell it for a higher price in the future, you might be tempted to take a risk.
The same applies to investing. Risks can be taken if you can stomach them and if there’s a potential positive outcome to be generated. On the other hand, if you know you will need access to your cash in the short term, you may wish to limit the risks you’re taking.
It's worth, therefore, understanding the various risks you can face as an investor. In this article, we’ll tackle two – systematic and non-systematic risk.
“Systematic risk is hard to avoid. It’s caused by wide macroeconomic or geopolitical factors and applies to the entire stock market.”
What is it? Systematic risk is hard to avoid. It’s caused by wide macroeconomic or geopolitical factors and applies to the entire stock market, rather than one specific industry or stock. It can also be tricky to predict – see the Covid-19 pandemic, for example.
What can you do about it? Other risk factors that simply cannot be helped include natural disasters, recessions and wars – i.e., far-reaching events with enormous potential global impact.
The only way to completely eradicate systematic risk would be to avoid being invested in the stock market altogether. That’s why it’s important to understand your risk tolerance. How would you feel about delaying one of your life goals by a couple of years if a recession hit? If the thought of that gives you shivers, you may need to reassess how much of your investible money you put into the market.
“If all of your money is invested in the shares of hotel chains, a drop in travelling will hit your entire portfolio.”
What is it? This risk is tied to a specific stock or industry sector, rather than being reflective of the general economic landscape. It can be caused by things like regulation changes, employees going on strike or product recalls.
Warehouse workers taking industrial action, for example, may impact e-commerce companies. Carmakers may be affected if regulators tell them their vehicles need to meet certain emissions standards, and so on.
What can you do about it? Non-systematic risk can be minimised through diversification –spreading your risk by having a portfolio that covers a wide variety of different companies and sectors.
The conventional wisdom is if one industry or company is having a rough patch, the impact on your overall portfolio hopefully should be minimised if you’re diversified across sectors and businesses.
If all of your money is invested in the shares of hotel chains, a drop in travelling will hit your entire portfolio. If, however, you’re invested in hotels, supermarkets, automakers, tech companies and banks, it’s less likely you’d be impacted by a specific trend.
Up next: We look at inflation risk and opportunity cost.
Capital at risk.
When you want your portfolio to generate income, dividend-paying stocks seem like a no-brainer. These are assets that can generate stock-market returns while also paying out regular cash distributions. That all sounds pretty good.
For many of us with long-term investing plans, finding assets that provide income is appealing. Regular payments generated by the securities we’ve purchased can make it easier to put cash away for 5+ years.
When you invest, your capital is at risk.