People invest money to earn a return on their money, but often they receive less than expected — indeed, sometimes the return can be negative, when the investor receives less than the initial investment. With some investments, the entire investment can be lost. Investment risk is the chance that you will receive less than the expected return from an investment, and differs according to the type of investment.
Investors differ in their risk tolerance, which is the risk that an investor is willing to take or is comfortable with in the hope of getting higher returns. Investors who are risk averse don't want to risk much, so they will deposit their money in a FDIC insured bank account or buy a certificate of deposit or United States Treasuries. In exchange for their little or no risk, they will earn very little as a return. At the opposite end of the spectrum, there are investments, such as options, where risk-seeking investors can earn several times their investment within a short time or lose the entire investment. A risk-indifferent investor is one who regards only the expected return without any consideration for the risk.
For every investment, there is a risk-return tradeoff, which is the correlation between the expected return and the risk of an investment. It makes sense to demand a higher return for a riskier investment; otherwise, why risk losses? If Treasuries and options had the same return, no one would buy options, since it is easy to lose their entire investment in options, where there is virtually no chance of losing money buying Treasuries. In fact, because Treasuries are backed by the full faith and credit of the United States government, Treasuries are considered free of credit default risk, which is the risk that a bond or other security that pays interest, will not pay the interest or even the principal.
Because investors can invest in a wide variety of securities or assets with widely differing risks, no one would consider an investment that had risk unless the potential return on the investment exceeds a safer investment — the greater the risk, the greater the potential return, or risk premium, must be. The required return of an investment is what the investment must pay to induce people to invest and to compensate them for their risk of capital. The required return can, thus, be componentized into a risk-free return plus the risk premium.
Required Return = Risk-Free Return + Risk Premium.
The risk-free return demanded for a given maturity is usually considered set by a U.S. Treasury of the same maturity, so the risk premium can be approximated thus:
Risk Premium = Required Return – Treasury Yield
Types of Investment Risk
There are many types of risk that are caused by different factors, or which affect different investments to varying extents. Some factors affect most investments and are called systemic risks. Other risks, such as sector risks affect only a particular sector of the economy. Some risks are specific to a business or asset, and are called nonsystematic risks, or diversifiable risks, because such risks can be lowered by diversified investments.
Inflation risk is a systemic risk that lessens real returns due to the decreasing purchasing power of the returns. Although inflation negatively affects most investment returns, currency inflation can sometimes yield higher returns, such as when it is sold short in a currency transaction.
Interest rate risk is a risk that lowers yields or returns due to changes in the prevailing interest rate. Interest rate risk can affect different securities in different ways. The price of bonds in the secondary market, for instance, varies inversely to interest rates — when interest rates rise, the price of bonds drops, and vice versa.
Business risk is any risk that can lower a business's net assets or net income that could, in turn, lower the return of any security based on it. Some business risks are sector risks that can affect every company in a particular sector, while other business risks affect only a particular company. Higher mortgage rates can increase the business risk for real estate or construction companies, for instance. However, even similar businesses can have widely different risks depending on the quality of management and the resources that are available to the business.
Financial risk is the risk that a business will not be able to make payments due to its debt load. Interest and principal must be paid on borrowed money — failure to make payments can force the business into bankruptcy. A business with large amounts of debt relative to income does not have much reserve for unexpected expenses or lower income, and can fail if the economy sours or if it encounters some other factor that lowers income or increases expenses.
Model risk results where the risk of pricing models is not accurate or where the mathematical simulation of risk is misleading, which was one of the major reasons why banks took on too much risk that precipitated the Great Recession in 2007.
Operational risk is the risk that a firm does not operate as it should or fails to prevent risk from arising in its business, usually because the firm lacks sufficient internal checks and balances. For instance, a rogue trader can incur massive losses for a bank, such as when Nick Leeson caused a loss of £827,000,000 for Barings Bank — the oldest investment bank in Britain that had financed the Napoleonic wars, Louisiana purchase, and even the Erie Canal — in the 1990s which resulted in its collapse in 1995.
Tax risk is the risk that a taxing authority will change tax laws that will affect an investment negatively. Higher taxes on investment income reduce real returns and can lower the prices of investments in the secondary markets. Higher taxes on businesses will lower their net income, which will usually lower its stock price, and may lower its bond prices in the secondary market if their credit rating is lower as a result of the lower income.
Market risk is the risk that market conditions can depress investment returns. For instance, the prices of securities depend on general supply and demand that fluctuates independently of any security in particular. Market risk depends on economic conditions, such as inflation, consumer sentiment, or credit availability.
Although market risk affects most investments, some investments are affected more than others. How much an investment is affected by market risk is measured by its price volatility, especially in its relationship to an index of similar investments. For instance, some stocks rise higher when the market rises, or falls lower, when the market drops. Sometimes an investment may be countercyclical to other similar financial instruments. Thus, some stocks rise when the general market falls and vice versa. Often, the market movement is measured by a broad index, such as the S&P 500 Stock Index.
Event risk is the risk of an event that can have an impact on the potential return of an investment. Generally, event risk is risk that affects a single company and its securities, such as the loss of a major lawsuit or an accounting scandal. Sometimes event risk can affect a number of securities, such as the political risk that a country will do something that will drive down the prices of any securities issued by companies located there, such as increasing taxes, discouraging foreign investment, or in extreme cases, nationalizing the companies without proper compensation.
Foreign exchange rate risk is the risk that the value of foreign investments will be adversely affected by changes in the foreign exchange rate.
Finally, there is liquidity risk, which is the risk that an investment cannot be sold quickly for a reasonable price. Real estate, for instance, is an illiquid investment because it takes considerable time to sell unless it is sold below market value.
These are the general risks that affect many investments. There are, however, other risks that affect specific types of investments. Most of these risks can only be known by understanding the business or the investment.