Investing Risks You Should Be Aware Of - The Humble Penny (2024)

Investing Risks To Be Aware Of.

In every situation in life, there are two things that will always exist: Uncertainty and Risk.

Both are often used interchangeably but should not be.

Uncertainty is inherent and exists no matter what. It is an objective feature of our universe.

Risk, on the other hand, is in the eye of the beholder i.e. it is subjective.

Your risk attitude is another way of doing something (i.e. take risk) in order to get a reward (i.e. return).

Investing risk is the type of risk that you are exposed to when you put your money to work.

Doing nothing with your money also exposes you to risks such as inflation or even bank failure.

The fact that such risks exist is not a bad thing and should not paralyse you from inaction.

Most people do nothing with their money because there is an unfamiliarity that comes with risk, which in itself can induce fear.

This is not helped by necessary disclaimers such as .“The value of your investments can go down as well as up. Past performance is not an indicator of future success”.

Understanding the risks that exist when you invest is an important part of ensuring that you know what you’re doing.

Such understanding will give you confidence in the days when your investment performance might not be going in the desired direction.

It will also help you to ensure you’ve considered ways of reducing such risks possibly by changing your positioning or getting some protection e.g. an insurance.

Finally, having a good understanding of such risks will help you assess investment opportunities with the confidence to say, No, to ones that aren’t helping you achieve your goals or are just outright scams.

Although below there are an array of risks, note that not all of them apply to all types of investments you can make. So do not be overwhelmed!

Below is a list of investing risks you should be aware of:

Risk of Inflation

This is the risk that prices keep rising and the purchasing power of your money falls from time to time. I.e. You are able to buy less with your money today than you were able to yesterday.

This is an important risk if you currently have cash sitting in a current account doing nothing. Inflation risk is a silent assassin and rises to erode value.

This risk becomes worse if you live in a country with high or double-digit inflation rates. The UK and US typically have inflation rates of circa 2%.

This means, to stop the value of your money eroding over time, you’d want it earning a return on investment of at least 2% on average.

Liquidity Risk

This refers to the risk that you cannot easily convert your investment into cash. It’s one of the most important considerations for an investment, especially if cash flow is important to you.

Cash is the most liquid form of an asset. Investments with low liquidity include buy-to-let property investments, which require alot of cash outlay to get skin in the game but can be quite a challenge from a liquidity perspective.

Alot of Brits, for example, are millionaires by net assets, with a huge portion of their wealth stuck in their homes.

This inability to convert that wealth into cash is another example of liquidity risk in action.

This is why an important consideration on your path to financial independence is the need to balance liquidity and returns.

Note that you can ofcourse have highly liquid investments that potentially generate high returns. Investing in shares is one such example.

Related: Index Fund Investing and the Simple Path to Wealth

Another fairly illiquid investment is investments into Venture Capital Trusts (VCTs).

These are great for experienced investors with a long-term view and tax savings/efficiency as a priority. The liquidity problem is solved somewhat by payments of dividends.

Market Risk

It’s the risk you face by being invested in the marketplace. For example, if there is a terrible stock market day across the board, and the market falls, your investment will also be affected.

Such a risk can also be seen in other markets such as the property market, livestock market, gold market etc.

Market risk is one risk that cannot be diversified away. It’s just accepted risk for getting involved in the related investing activity.

Foreign Exchange (FOREX) Risk

FOREX risk arises from investments made in foreign currencies, which can either work in your favour or against you.

For example, imagine you live in London and let outa holiday home in Majorca, getting paid your rent in Euros.

With every move in the Sterling vs Euro rate, you also get affected because you will at some point likely convert your Euro earnings to Sterling.

FOREX risk is more of an issue with short-term investments than long-term ones, as the latter has time to level off.

Business Risk

Business risk is the type of risk you get from putting money into a specific business. Another way to look at this is as risk from the operations of a business.

In my opinion, the only people who should be doing this are people who know how to value companies, and/or are savvy investors.

A good example is when you by the shares of a specific company you like. You’re taking on possible risks of bankruptcy, fraud, reputational damage etc.

However, you could also be compensated really well for taking such a risk if the business performs well. For taking such a high risk, you’d expect a potentially high reward.

Interest Rate Risk

You face this risk if your investment is debt related e.g. a bond or a mortgage.

A bond (where you’re the lender) paying a fixed rate of say, 3%, will decline in value when interest rates start rising.

With a mortgage (where you’re the borrower) paying a fixed rate of say, 3%, an interest rate rise will not increase your mortgage rate, therefore making your deal more attractive.

Political Risk

The nature of politics in the country you’re investing can have a positive or negative effect on the perceived confidence in that country.

That perceived confidence can drive Foreign Direct Investment and ultimately the stock markets and the valuation of companies.

Political risk also has an impact on the value of a country’s currency, therefore, either enhancing or depleting the value of your investment.

Credit Risk

This refers to the inability to pay as a payment falls due. Businesses suffer credit risk when their debtors don’t pay and result in bad debts.

Individuals and companies have profiles that show their payment histories and likeliness to pay.

Good or bad credit risk profiles drive your ability to do business or investments with another party or not.

To see what your profile says about you, get your free Experian Credit Score.

Counterparty Risk

It’s the risk that a counterparty that you’re doing business with fails. A simple example is with regards money that you might have in your current account.

If a bank goes bust, you’re only protected by the Financial Services Compensation Scheme to the tune of £85,000.

If you have alot more than £85,000 with one bank, you not only face concentration risk but you also potentially face a high counterparty risk particularly if it’s a bank with low creditworthiness.

Regulatory Risk

A change in the rules of play can affect your investments, especially as these are usually driven by political motivations.

Some countries have regulatory changes that make the rich even richer, as can be seen with the changes in the US.

Changes could also have adverse impacts on your investment. For example – The requirement for a workplace pension to be provided by every business no matter the size is a UK specific risk.

Such a change will make it harder for companies of all sizes to operate due to higher costs and might result in higher prices down the line.

Manager Risk

This is the risk that you take when you pay an investment manager to make investment decisions on your behalf.

Most of these as I have told you previously cost alot in fees and don’t outperform the market. So why not do it yourself and follow the simple path to wealth?

Related: Index Fund Investing And The Simple Path To Wealth

In conclusion, now that you’re aware of the key risks, the important thing to remember is that these are not against you necessarily.

They just exist. And not all risks relate to a specific investment you might make.

[yellowbar]Diversification is a force for good and reduces a lot of the risks you might face with your investments.[/yellowbar]

Just make sure you ask yourself next time you’re about to make an investment: What risks do I face with this investment?

This alone is a massive step forward in your journey towards successful investing.

Things to remember:

• Risk is in the eye of the beholder
• Diversification is your shield

Things to forget:

• “The value of your investments can go down as well as up. Past performance is not an indicator of future success”

Related:

Understanding Index Fund Investing

Are you more confident about making your own investing decisions if not already?

Do please share this post if you found it useful, and remember, in all things be thankful and Seek Joy.