IN THIS LESSON

Investing in financial markets offers the promise of substantial rewards, but it also entails inherent risks. As investors navigate the complexities of the market, they must carefully weigh the potential returns against the various types of risks involved. In this post, we’ll explore when investing risks outweigh the rewards and how investors can strike a balance between them.

In this Part 5 of Investing 101, we’ll cover investment risks and striking the right balance between risks and rewards to achieve our financial goals.

Before delving into the balance between risks and rewards, it’s crucial to grasp the two primary types of investment risks: systematic and unsystematic.

Unsystematic Risk

Unsystematic risk, or specific risk, pertains to individual investments and can be mitigated through diversification.

Business Risk: This risk is associated with a particular company’s operations, industry, or financial condition. Factors such as competitive pressures, management decisions, or technological changes can impact business risk.
Financial Risk: Financial risk refers to the risk associated with a company’s financial structure, including its use of debt and leverage. High levels of debt can increase financial risk and make a company more vulnerable to economic downturns or interest rate fluctuations.
Regulatory Risk: Changes in government regulations or policies that impact the operations or profitability of businesses lead to regulatory risk. Industries such as healthcare, finance, and energy are particularly susceptible to regulatory risk.
Legislative Risk: Legislative risk refers to the risk associated with changes in laws or legislation that affect businesses or investments. Changes in tax laws, environmental regulations, or trade policies can impact investment returns.
Political Risk: Political instability or uncertainty in political environments pose political risk. Government instability, geopolitical tensions, or changes in leadership can impact investments in both domestic and international markets.
Sovereign Risk: Investing in foreign countries carries sovereign risk. Political instability, economic volatility, or currency devaluation in foreign countries can impact investment returns.
Liquidity Risk: This risk refers to the inability to buy or sell assets quickly and at a fair price. Investments with low liquidity may be difficult to sell without incurring significant price discounts or delays.

Systematic Risk

Systematic risk, also known as market risk, impacts the entire market and cannot be diversified away. Examples include economic downturns, interest rate fluctuations, and geopolitical events.

Market Risk: This is the risk of overall market fluctuations impacting the value of investments. Factors such as economic downturns, geopolitical events, or changes in investor sentiment can influence market risk. Common investments affected by market risk include equities, mutual funds, and ETFs.
Interest Rate Risk: Fluctuations in interest rates impact the value of fixed-income securities like bonds. When interest rates rise, bond prices typically fall, and vice versa.
Reinvestment Risk: Investors may face reinvestment risk when they have to reinvest cash flows from an investment at a lower interest rate than the original investment. This risk is common in fixed-income securities like bonds or certificates of deposit.
Inflation Risk: Also known as purchasing power risk, inflation risk refers to the risk that investments will lose value over time due to inflation eroding purchasing power. Investments that fail to outpace inflation may result in a loss of purchasing power over time.
Exchange Rate Risk: Fluctuations in currency exchange rates pose exchange rate risk. Investors holding assets denominated in foreign currencies may experience losses or gains due to changes in exchange rates.

Average Returns Over a 20-Year Period

While past performance doesn’t guarantee future results, historical data can offer valuable insights into average returns over the long term. According to historical market data, the average annual return of the stock market has been around 7% to 10% over a 20-year period, accounting for inflation.

This suggests that by investing in a diversified portfolio of stocks and holding onto investments for 20 years, investors can expect to earn an average annual return of approximately 7% to 10%. It’s important to note that these returns can vary based on market conditions and individual investment choices.

Opportunity Cost

Apart from understanding these risks, investors must also consider opportunity cost — the potential value lost by choosing one investment over another. Opportunity cost reflects the trade-offs involved in allocating resources, such as time, money, or effort, to one investment opportunity over alternative options. By weighing the potential risks and rewards of different investment choices, investors can make more informed decisions to optimize their investment portfolios and achieve their financial goals.

Balancing Risks and Rewards

As investors, striking the right balance between risks and rewards is crucial to achieving our financial goals. It involves assessing our risk tolerance, investment objectives, and time horizon, and diversifying our investment portfolio to mitigate risks while maximizing returns.

Diversification is key to managing investment risks effectively. By spreading investments across different asset classes, industries, and geographical regions, investors can mitigate unsystematic risk while maintaining exposure to potential returns. While diversification can’t eliminate systematic risks like market downturns, it can help cushion the impact on overall portfolio performance.

By understanding the various types of risks involved and conducting thorough research, investors can make informed decisions to optimize their investment portfolios and achieve their financial goals.

Lesson 5: Balancing Risks and Rewards