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What Does Risk Have To Do With Investing?

Contributor:
Securities Commission
Securities Commission

Every investment has risk.

Risk is the chance that an investment will not be as good as you expected or were promised.

It means that you might not get your money back and you might not get any additional returns (e.g. interest or dividends or capital growth).

A common saying about investment is "the higher the promised return,
the greater the risk". Experienced investors know that exceptions to
this rule are rare, and for most investors it is a good rule to follow.

So how do you make the right connection between investment risk and return?

Deciding on the level of risk that you are comfortable with is an
important part of choosing investments that are right for you.

Everyone has different levels of comfort or discomfort about risk.
It depends on your personality and circumstances. Knowing your risk profile will help you decide what investment risks you are prepared to take. You can assess your risk profile at www.sorted.org.nz

Types of risk

There are many kinds of risk.

Some risks apply to all investments - e.g. if the whole market for
investments falls everyone's investments will fall in value.

Some investments have risks specific to them - e.g. your shares in a timber company would fall in value if the world price for wood falls.

Every investment has its own risk - this is why it is important to find out about the risks of each investment you make.

Other risks
Some other types of risk are:

  • Capital risk - the investment fails and you may lose all your money.
  • Interest
    rate risk - interest rates might change during the term of your
    investment. For example, you lock in your money for two years at 5%
    interest. After one year interest rates rise, so you don't earn as much
    interest for the second year of your investment as you would if you'd
    been able to invest at the higher rate. Of course, the reverse happens
    when interest rates fall.
  • Liquidity risk - the risk that
    there might not be many buyers for an investment you want to sell. You
    may have to wait for a buyer, or sell at a lower price.
  • Credit
    risk - the risk that a company you buy an investment from may not be
    able to repay its debts. It may default on the money it owes you.
  • Industry
    risk - the risks that can affect a particular industry, such as
    shortages of raw materials, changes in consumer preferences, or loss of
    an export partner.
  • Currency risk - the risk that a company
    you invest in is affected by changes to the currency e.g. if the New
    Zealand dollar increases in value an importing company's share price
    might rise because it can buy more goods for fewer dollars. On the
    other hand an exporting company will get fewer dollars for its goods,
    and its share price might fall.
  • Inflation risk - the risk
    that your investment (e.g. a bond) does not earn enough interest to
    keep up with inflation. If your bond is earning 2% per year and
    inflation is 3% a year your bond falls in value over time.

This article was provided by the Securities Commission.

 

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