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What is Investment Risk?

Investment

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5.5.22 |

Become Wealth Editor

The Biggest Risk to Your Investments Could Be You

Investing inherently involves risk, and the biggest risk to your investments might just be staring back at you in the mirror. Investing inherently involves placing funds at risk, and when it comes to types of investment risk, the most significant variable often overlooked is the investor.

Renowned American investor, Warren Buffet, often referred to as the “Oracle of Omaha”, says success in investing is not defined by someone’s IQ.

“Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing,” he says.

Why? Emotional reactions, biases, or hasty decisions can impact even the smartest individuals and jeopardise the most well-thought-out strategies.

Let's explore why understanding and managing this is crucial for long-term investment success.

Understanding Investment Risk

Investment risk refers to the uncertainty or potential for financial loss associated with an investment.

At its core, risk signifies the potential for unanticipated loss of value.

The mere mention of ‘unanticipated loss' and 'value' together tends to send shivers down many spines.

Investment Risk, Practically Speaking

It's a common scenario: market fluctuations trigger panic, leading to impulsive decisions that can cost more than just money. These fluctuations in investment markets are just rapid repricing of assets, usually in response to some kind of new information in the form of breaking news. This news might relate to economic events, the outbreak of a new disease, a war, natural disasters, and so on. But even the worst breaking headline is rarely as scary as it first seems, anyone who’s paid the slightest attention to the mainstream media lately knows that! For investors, even the most awful news is unlikely to topple some of the world’s most popular investments, think about the likes of shareholders in Microsoft, for instance.

Microsoft is now the world’s largest publicly listed company, and if you’re reading this, the chances are you’re an investor in Microsoft, as it makes up a small portion of nearly all KiwiSaver Scheme investment holdings. When you think about it, the most unexpected news would be unlikely to significantly disrupt the operations of a corporation like Microsoft, who operates globally, and in such a diverse array of services. In fact, in many areas Microsoft face no credible competition. Think about the Microsoft Office suite of products, for instance. It’s scarcely feasible to see a scenario where Microsoft would go bust in the next few years. The same could be said for many other corporates which make up the major stock markets. Think of names like Coca Cola, Apple, Google, Toyota, Visa, McDonalds, and so on. As most investors spread their investments across various major companies and diverse sectors like real estate and bonds, the statistical likelihood of a surprise event which would make the values of all these assets simultaneously worth nothing, is basically zero. In the highly unlikely event that were to happen, we’d all have far worse problems than our investments.

So, safe in the knowledge that your investments are unlikely to all slump to a value of zero, what typically happens after an initial shock market reaction to bad news, is the market readjusts. It then eventually goes on to reach new highs. Sometimes the new highs take a few years to reach, while sometimes it is a much shorter timeframe.

Simply put, sometimes the greatest threat to your financial well-being is not the market but your own actions.

That said, investing does involve a degree of risk, and the value of investments can fluctuate due to various factors.

Here are some different types of investment risk:

Credit Risk

Credit risk arises when an issuer of a financial instrument (such as a bond) fails to meet its payment obligations. This risk is more prominent in fixed-income investments.

Government bonds, especially those issued by a stable central government, have the least amount of default risk and, as such, the lowest returns. Corporate bonds, on the other hand, tend to have the highest amount of default risk, but also higher interest rates.

Liquidity Risk

Liquidity risk is the potential difficulty of buying or selling an investment without causing a significant impact on its price. Some investments may have low liquidity, making it challenging to execute trades.

Typically, investors will require a higher return for illiquid assets which compensates them for holding investments over time that cannot be easily liquidated.

Interest Rate Risk

Changes in interest rates can affect the value of all investments, though this type of risk affects the value of bonds more directly than stocks and is a significant risk to all bondholders. When interest rates rise, bond prices typically fall, and vice versa.

Political Risk

Political risk is the risk an investment’s returns could suffer because of political instability or changes in a country. This type of risk can stem from a change in government, legislative bodies, other foreign policy makers, or even military control.

This is also known as geopolitical risk.

Inflation Risk

Inflation erodes the purchasing power of money over time. Investments that do not outpace inflation may result in a decrease in real (inflation-adjusted) returns.

Foreign-Exchange Risk

When investing in foreign countries, fluctuations in currency exchange rates can impact returns when translating profits or losses back into their home currency. In other words, foreign exchange risk (or exchange rate risk) applies to all financial instruments that are in a currency other than your domestic currency.

As an example, if you live in New Zealand and invest in an Australian stock in Australian dollars, even if the share value goes up, you may lose money if the Australian dollar depreciates in relation to the New Zealand dollar.

Emotional Risk

Risk is inherently tied to the unpredictability of the future.

However, it's essential to recognise that uncertainty cuts both ways — there's potential for positive outcomes, though our inherent bias often skews towards the negative.

Emotional risk, often referred to as psychological or behavioural risk, is a significant aspect of the investment process.

It involves the emotional and mental challenges that investors face, influencing their decision-making and potentially impacting investment outcomes. Buffett says investment “risk comes from not knowing what you’re doing” and an inability to control your emotions.

“If you cannot control your emotions, you cannot control your money,” he says.

From exuberance and greed during bull markets to fear and panic in downturns, emotional factors play a substantial role in shaping the volatile landscape of cryptocurrency investments.

Successful navigation of this market requires a careful balance between emotional resilience and strategic decision-making.

Here are some key components of emotional risk in investing:

Fear and Panic: Fear is a natural emotional response to perceived threats or uncertainties. With investing, fear can lead to panic selling during market downturns or periods of heightened volatility. Investors driven by fear may make impulsive decisions to exit investments, potentially locking in losses and missing out on potential recoveries.
Greed and Overconfidence: Greed and overconfidence can arise when investors experience success or a bull market. This may lead to a belief that high returns will continue indefinitely. Overconfident investors might take excessive risks, neglect proper diversification, or ignore warning signs. This behaviour can result in significant losses when market conditions change.
Regret Aversion: Regret aversion involves the fear of making a wrong decision and subsequently experiencing regret. Investors may avoid necessary adjustments to their portfolios or hesitate to sell underperforming assets, leading to missed opportunities or prolonged exposure to declining investments.
Herd Mentality: Herd mentality refers to the tendency of individuals to follow the actions of the majority, especially during market extremes. Following the crowd without careful analysis can lead to bubbles or market crashes. Investors may buy at market peaks and sell at lows due to the influence of the herd.
Loss Aversion: Loss aversion is the tendency to prefer avoiding losses over acquiring equivalent gains. Investors who are highly loss-averse may be reluctant to sell losing investments, hoping for a recovery. This can result in holding onto underperforming assets longer than advisable.
Confirmation Bias: Confirmation bias involves seeking information that confirms pre-existing beliefs while ignoring conflicting evidence. Investors influenced by confirmation bias may overlook warning signs or fail to consider alternative viewpoints, leading to suboptimal decision-making.
Short-Term Focus: Some investors may have a short-term focus, seeking immediate gratification or reacting to short-term market fluctuations. Overemphasising short-term performance can lead to a lack of patience and discipline, hindering the ability to achieve long-term investment goals.

How Do You Manage Emotional Risk?

Recognising and addressing emotional risk is crucial for investors aiming to make rational, well-informed decisions that align with their financial objectives.

Here are some ways to help mitigate emotional risk in investing:

Education and Awareness: Understanding common emotional biases and cognitive pitfalls can help investors recognise and mitigate their impact.
Long-Term Perspective: Focusing on long-term investment goals and maintaining a disciplined approach can reduce the influence of short-term emotions. As Buffett explains it, “The stock market is a device for transferring money from the impatient to the patient.”
Diversification and Risk Tolerance Assessment: Building a diversified portfolio aligned with an investor's risk tolerance can provide a buffer against emotional reactions to market fluctuations.
Professional Guidance: Working with financial advisers, such as the team here at Become Wealth, can provide objective insights and help investors stay on course during emotionally challenging periods.

Developing emotional resilience and adopting a disciplined approach can contribute to more successful and less emotionally driven investment outcomes.

Related articles:

Market Crashes and Volatility

Typically, a stock market crash is defined as a singular day in which a stock exchange experiences a decline of at least 10%. However, it's not solely limited to a specific percentage drop.

According to Terry Marsh, a finance professor emeritus at the Haas School of Business at the University of California Berkeley, a market crash can also be "anytime there's suddenly a lot of volatility that makes you wonder whether the world is coming to an end tomorrow”.

Tech Bubble of the 2000s

In the late 1990s, the dot-com bubble saw a surge in technology stocks, with investors driven by a fear of missing out (FOMO), excessive optimism, and a speculative frenzy.

Many investors, influenced by emotions and overconfidence, overlooked traditional risk factors and ways to value companies. This led to an unsustainable rise in stock prices, largely for companies which were not making any profits.

They invested heavily in overvalued tech companies, expecting the trend to continue indefinitely.

The subsequent burst of the bubble resulted in panic selling, significant losses, and a lasting impact on investor confidence.

Pandemic Market Turmoil, 2020

In early 2020, the global spread of Covid 19 triggered widespread concern.

As the virus's potential economic impact became apparent, the stock market experienced significant volatility.

On March 16, with the announcement of mandatory lockdowns, the Dow Jones Industrial Average plummeted nearly 13%, and the S&P 500 dropped by 12%.

The fallout was profound: businesses struggled, leading to layoffs and closures, and sectors such as airlines and hospitality were severely affected by travel restrictions.

Those who panicked and sold near the market lows missed the subsequent recovery as the true nature of the virus became clearer.

Your Risk Profile

Basic theories dictate the higher the return you are after, the more risk you are willing and will have to take.

Cash has the lowest risk, and therefore the lowest expected return. Of the four major asset classes (cash, bonds, property, shares), shares have the highest risk and the highest expected return.

As an investor, you are often asked to assess your risk profile and given a simple label like balanced or aggressive.

But, here at Become Wealth we know each investor is unique and putting your risk profile into a predetermined category is not always meaningful. What is important is your financial comfort and understanding about what your desired outcomes and the risks associated in achieving them.

Tailoring Risk to Your Timeline

Your investment horizon significantly influences your risk tolerance.

If retirement is decades away, you possess the luxury of weathering short-term market fluctuations and a chance to recover from any potential downturns that happen while your money is invested.

Conversely, funds earmarked for imminent objectives, such as a home purchase in a few years, demand a more conservative approach.

In essence, align your risk appetite with your financial goals.

A long-term retirement portfolio, such as a KiwiSaver Scheme, can lean towards higher-risk assets, capitalising on potential growth over decades.

In contrast, short-term objectives necessitate a more cautious stance to preserve capital.

The Bottom Line: Slow and Steady Wins the Race

While the complexities of the financial markets are undeniable, often the most substantial risk comes from within – the person staring at you in the mirror.

By understanding your motivations, tolerances, and timeline, you can navigate the investment landscape with greater confidence and clarity.

After all, in the trade-off between risk and reward, self-awareness remains your most potent ally.