Realising the Risks Involved in Investing - dummies

By David Stevenson

Part of Managing Your Investment Portfolio For Dummies Cheat Sheet (UK Edition)

Unfortunately, many investors look at risk in a very simplistic way. A typical query about risk may start with an investor asking, ‘How much capital may I lose if I invest in an asset?’ But risk involves much more than this narrow sense reveals and comes in many shapes and sizes. Try and think about risk in a much wider, sense and use the following pointers to guide you:

  • Credit risk: If you buy a bond, what’s the chance of the issuer defaulting on the final payment (or the regular interest payments)?

  • Currency risk: Your investment in a foreign asset may increase in value but the currency in which it’s denominated may move in the opposite direction.

  • Idiosyncratic risk: If you employ a manager to manage your money, what risk are you taking if he makes a bad decision?

  • Legal risk: Will regulators decide to change the rules governing your investment?

  • Leverage risk: What happens if you borrow too much money and the cost of leverage starts to work against your investment?

  • Liquidity risk: Your asset may increase in value but become increasingly difficult to sell; that is, it may become more illiquid, which is a risk if you need to access that investment immediately to raise some much needed cash!

  • Maximum drawdown: The potential maximum loss over a period of time that may hit your financial asset. Many stock markets can easily lose 20 or even 30 per cent in a year, whereas most bonds rarely lose more than 10 per cent in any one year.

  • Systematic risk: How an asset may respond to risks within the system; that is, how closely correlated the asset is with wider financial assets. If the US economy nosedives, is your asset going to crash in value as well?

  • Volatility: How much the value of a share, bond or commodity varies on a daily basis. For many people, high volatility implies higher potential risk.