What is investment risk?
The word Risk might sound alarming in any ordinary situation, as it sometimes refers to recklessness or rashness. In investment though, risk could potentially come with rewards. Risk refers to the level of uncertainty that comes in any financial decision.
When buying shares in any company, investors are tied to how that company performs as well as other factors. If the company is performing positively, your share could increase in price, but if that same company is underperforming, you run the risk of owning shares with a market price lower than the price you initially paid. This is essentially investment risk.
There are different levels and types of investment risks, and generally speaking, the higher the risk you’re prepared to take on, the higher the potential returns.
What are the different types of investment risk?
Market risk involves the overall performance of the financial market. You can earn or lose depending on different factors such as market sentiment factors such as inflation level, changes in interest rates, politics or global events like COVID-19. Market risk is also known as non-diversifiable risk, as even diversification, one of the most popular tactics against risk, might not be sufficient to secure your investment fully, that’s why some people also choose to invest in assets outside the stock market.
In other words, you can’t escape from market risk as it does not depend on your capability of making financial decisions. Market risk is applicable to all assets or liabilities, so a negative or positive change in the financial market can affect all market prices, regardless of the individual level of security.
Business risk is the ability of a company to generate enough revenue to meet its target levels. One measure of business risk is a company’s ability to meet its target profit. Even if companies are considered safe or low volatility risk, there will always be ups and downs, as the stock price is tied to factors like companies failing to meet its objectives or competitors significantly reducing the price of a similar product.
How can I adjust the level of risk?
There are 3 common ways the level of risk can be adjusted. The first one is time; the longer you hold your investment, the higher the chance to obtain a positive return as there’s more time to make up for the losses of a down market. However, most stocks go up and down over time, so there’s always the risk of getting little or negative returns.
The second way to adjust the level of risk is diversification. By investing in different assets and industries, there’s no need to rely on the performance of one single company, as all companies have different levels of risk and reward. Some newer companies like startups can experience more changes and volatility than well-established companies, but they could also experience rapid growth and higher returns. Also, industries might react differently to the same type of event. For example, if you hold stocks only in the retail sector and an adverse event like a supply chain crisis hits, it might affect the entire industry. So, investing in any of the other 11 market sectors is another way of diversifying your portfolio.
The Front Score uses Markowitz’s Modern Portfolio Theory to find the highest possible return within a reasonable level of risk. Nobel prize winner Harry Markowitz argued that lower risks do not always equal low returns, and that there’s a way to earn the best returns possible by assessing the individual level of risk tolerance and desired returns.
The Front Score can help investors generate higher returns by assessing not only how profitable a single investment might be, but rather how much risk and returns it could add to the overall portfolio, and therefore how a particular asset could fit in your portfolio optimization.
One more way to mitigate risk is to spread your investments over time, by not buying all your intended shares at once, but rather buying consistently over a period of time.
Is there a way to invest with 0 risk?
Risk is a key element when assessing the possible investment return. There will always be a certain amount of risk, so lower risk doesn’t always equal a sound investment strategy. However, combining investing over time, diversifying your portfolio and spreading your investments could significantly reduce your risk of getting negative returns.
Download the Front app from any iOS or Android device and connect your brokerage account to get your Front Score, for free.