What is financial risk?
Financial risk is the chance you may lose money or your returns may be less than you expected. In the investing world you often hear the term ‘risk-return trade-off.’ The concept behind the risk-return trade-off is that the more risk involved in an investment product, the greater returns you may receive. With every investment product the risk varies, and the same is true for the type of risk each product might encounter.
There are a number of different types of financial risk with the four most common being market risk, counterparty risk, concentration risk and liquidity risk. Here’s a breakdown of each of them:
Market risk is the risk that the value of an asset may decrease due to changes in market factors. Market risk is an umbrella term for equity, currency and interest rate risk.
- Most commonly associated with shares, equity risk refers to the financial risk in holding equity in a particular investment. For example, as shares constantly fluctuate in value there is the risk of loss due to a drop in the market price. However, those who plan to invest for the long-term are generally able to weather downturns in the market. This is because over long periods of time the market does tend to recover.
- Exposure to currency risk occurs when investing in foreign assets. Exchanging one currency to another could leave you open to the risk of currency depreciation negatively affecting your assets.
Interest rate risk
- Those invested in bonds, or considering investing in bonds, should be aware of interest rate risk. When interest rates move up, the value of bonds typically falls. In Australia interest rates are reviewed every month by the Reserve Bank of Australia, which has left interest rates on hold since August 2016. Learn more about how interest rates can affect bonds here.
This risk refers to the possibility that the opposite party (also known as the counterparty) you’ve entered into a contract with will not honour their contractual obligations. Most financial transactions will carry an element of counterparty risk. However, investors are generally exposed to this type of risk when investing in fixed-income assets such as bonds.
When you invest in bonds you should receive a regular payment, referred to as a coupon, and when the bond reaches its maturity date you should receive your full investment back. However, there is always the risk that the counterparty is unable to make these payments.
Concentration risk is when an investor’s portfolio is not diversified to spread risk and safeguard against changes in the market. An example of concentration risk is when an investor’s portfolio is made up of only one entity. For example, an investor would be exposed to concentration risk if they were only invested in shares. If share prices as a whole were to plummet, this investor would have no other investments to fall back on. Another more extreme example is if an investor only owned shares in one sector, such as mining.
Related article: To Diversify Or Not To Diversify
Liquidity describes how easily an asset can be bought or sold in a market place without affecting the asset’s price. Liquidity risk refers to the risk of not being able to sell an asset fast enough to avoid a loss. An example of this is in real estate, where it may take longer to sell a house than expected, in which time the market could set a lower value for your house than you think it’s worth.
Before you take the plunge
Keep in mind the risk-return concept, as to reach your investment goals you may need to accept a certain level of risk. Taking the time to consider potential risks can help you set your expectations and put measures in place to prepare for all outcomes.
After all, what would investing be without risk? It would be free money, and unfortunately that’s unlikely to ever happen.
It’s always a good idea to do your research and to regularly review your investments, particularly if your circumstances or investment goals have changed. If ever in doubt, seek professional financial advice.
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