Preparing a financial plan for yourself in the US can be a whole new adventure for you as an immigrant. However, when you know what to look for, you can face the challenge with confidence.
At MYRA, our goal is to help you create an investment plan that is right for you. Here are the eleven investment risks to look out for when choosing your investments – consider your asset allocation, risk tolerance and time horizon when making your decision.
This article describes the different types of risks that are commonly encountered when investing. In particular, the article discusses investment risk, systematic risk and unsystematic risk.
What is the investment risk?
Most investments do not have a guaranteed return. This is because you take a certain amount of risk when investing. Each type of investment carries different types of risk.
In general, the more risk you take, the higher the potential reward. Alternatively, the lower the risk you take, the lower the potential reward. This can be stated on the stock exchange with potential returns and on the bond market with interest rates. You also need to take into account that a completely risky portfolio will suffer major slumps in the stock market, which means potential losses. If you take very little risk, you can miss out on potential profits.
Investment risk is the uncertainty as to whether the realized or actual return on an investment corresponds to the expected return. The uncertainty stems from the many types of risk discussed below.
The overall risk is a combination of systematic and unsystematic risk. It is measured in terms of the standard deviation of the ten risks discussed below. Typically, the more securities that are added to the portfolio, the lower the unsystematic risk.
Systematic risk (also known as market risk, non-diversifiable risk)
The systematic risk or market risk is integrated into the investment market. It cannot be eliminated through diversification or targeted variation of the investments in your portfolio in order to reduce the risk. Here the risk of general security in the market is influenced by changes in the economy.
Purchasing power risk (inflation risk)
Purchasing power risk, also known as inflation risk, is the likelihood that inflation will reduce the real value of an investor’s wealth. Fixed income assets, like debt securities, are hardest hit by inflationary pressures. This is because there is no guarantee that cash flows will not be affected by inflation, which will reduce their future value.
This is a type of risk where income available for reinvestment must be reinvested with a lower rate of return than the investment that generated the income.
Investments with a longer term and a high preliminary cash flow have the highest risk of a reinvestment rate. Zero coupon bonds and non-dividend stocks are not subject to reinvestment risk.
Interest rate risk
Interest rate risk is the likelihood that changes in interest rates will affect the value of the security. When interest rates rise, the value of bonds falls and usually has a negative impact on stocks.
Exchange rate risk (currency risk)
Exchange rate risk is the risk that a change in the value of the dollar and the value of the foreign currency during the investment period will adversely affect the investor’s return.
Exchange rate risk may affect investments in a foreign company or a domestic company that has supplies or customers in other countries.
Unsystematic risk (also known as non-market risk, diversifiable risk)
The unsystematic risk is only valid for a single security, a company, an industry or a country. This risk can be reduced by having a portfolio of just ten stocks. In other words, diversifying your investments can drastically reduce the likelihood of unsystematic risk. There are many different types of unsystematic risk.
The first type is business risk. It is viewed as an uncertainty of the operating result. Utilities have relatively stable and stable income streams and have less business risk. However, companies like automakers have unstable operating results and therefore have higher business risk.
The second type of risk is financial risk, which is the risk that a company’s financial structure will adversely affect the value of the investment. Corporations, government agencies, financial markets, and individuals can all be exposed to financial risk. For example, a company might not have enough cash flow to meet its debt or a government might default.
Another type of unsystematic risk is the risk of default. The risk of default is the risk that a borrower will be unable to meet their debt obligation. Rating agencies rate bonds issued by companies and municipalities in terms of their probability of default. U.S. government commitments are considered risk free. The greater the risk, the higher the interest rate. This risk does not apply to stocks, however, and bonds with a higher risk of default usually have a higher interest rate risk.
In addition, political risk is another type of unsystematic risk. This is the risk that a country’s politics or economy can negatively affect investments. The United States has low political risk, while foreign investment has higher political risk. Some examples of political risk are trade barriers, taxes, legislation and administration.
Investment manager risk
Investment manager risk is the risk associated with the skills of the manager of a mutual fund or account. It can refer to changes in investment style or changes in the management team. In general, all losses resulting from the mistakes, negligence and incompetence of the managers of a financial portfolio would be at the risk of an investment manager.
Liquidity risk (marketability risk)
Liquidity risk reflects the ability to sell an asset quickly at a competitive price. Marketability risk is the ability to find a suitable market in which the investor can sell the investment.
Real estate is marketable but usually not liquid. Alternatively, Treasury bills are both liquid and marketable. For this reason, cash is the most liquid and marketable commodity. If an investment is less liquid or less marketable, there is a higher risk.
The last type of risk is known as tax risk. This shows the likelihood that taxation on investment gains or losses can adversely affect the return on an investment. This can happen when a company does not properly account for taxes. This would reduce the level of profits and returns for the stakeholders.
You need to understand your tolerance for risk
Overall, you need to diversify your investments whenever possible to reduce unsystematic risk. Note, however, that the systematic risk is beyond your control and depends on the economy. When deciding what to invest your hard-earned money in, consider the appropriate asset allocation for your age, risk tolerance, and time horizon. If you do, you will be well on your way to building a strong financial future.