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Know how to manage investment risk

Know how to manage investment risk

There is no such thing as a risk-free investment as all investments involve some degree of risk. Whether you are investing hundreds or thousands of dollars, it is important to understand that to gain the potential rewards of investing, you must be prepared for the potential risks. 

You are responsible for deciding how much risk you want to take and therefore for mitigating against such investment risk.

Some examples of risks may include: 

  • Market Risk – Economic, technological, political, or legal conditions may affect the value of investments.
  • Interest Rate Risk – When interest rate increases, the value of fixed-rate investments drop. The risk to savings and loan rates if interest rate change
  • Inflation Risk - The possibility your purchasing power will be reduced because the value of your investment does not keep up with inflation.
  • Capital Risk - Potential higher returns usually mean there is a higher risk.
  • Counterparty Risk - The uncertainty that an organisation contracted to provide an investment service is not able to do so.
  • Longevity Risk - The possibility of outliving your savings.
  • Volatility Risk - The risk of a change of price of a portfolio because of changes in the volatility of a risk factor.
  • Liquidity Risk - Uncertainties of being able to sell an investment quickly enough to minimise loss.
  • Opportunity Risk - Uncertainty that a better opportunity will be available after irreversible investment decisions have been made.

Managing Risk

There are two basic investment strategies that can help balance risk and reward: 

  1. Asset allocation
  2. Diversification

Asset allocation refers to the different weightings of stocks, bonds, shares, or cash in your portfolio. Diversification takes this process one step further by spreading your money across different investments within the same asset class. Instead of putting all your money in one type of investment, spread your money across different types of investments.  Diversification is not a guarantee that you will not lose money on your investment, but it does enable you to reduce your risk of losses while possibly increasing your return potential across a portfolio of investments.

Risks may also vary from one type of investment to another; meaning the level of risk you take on is up to you. An investor should consider their time horizon and risk tolerance before committing to an investment.