Investment risk Glossary
Cash Risk: When you hold a substantial proportion of your assets in cash, near cash or money market instruments, you might not participate fully in a rise in market values of the asset classes you could otherwise invest in. As explained above, cash is also likely to be exposed to inflation risk.
Concentration Risk: The risk of a portfolio being too concentrated in particular positions or too exposed to certain issuers. This can exacerbate market, liquidity and counterparty risk.
Counterparty Risk: The risk that the bank is unable to meet its financial obligations, i.e. return a depositor’s money, or the failure of a counterparty to meet its obligations leads to a financial loss. In the event of either the issuing institution or counterparty being unable to meet its financial obligations the investor may get back less than invested and at worst lose all of the capital invested. Counterparty risk can exist in credit, investment, and trading transactions, especially for those occurring in over-the-counter (OTC) markets. Financial investment products such as stocks, options, bonds, and derivatives carry counterparty risk.
Country Risk: Country risk refers to the risk that a country won’t be able to honour its financial commitments. When a country defaults on its obligations, it can harm the performance of all other financial instruments in that country – as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options, and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a large deficit.
Credit or Default Risk: Credit risk is the risk that a borrower will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is particularly concerning to investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal government, have the least amount of default risk and, as such, the lowest returns. Corporate bonds, on the other hand, tend to have the highest amount of default risk, but also higher interest rates. Bonds with a lower chance of default are considered investment grade, while bonds with higher chances are considered high yield or junk bonds. Investors can use bond rating agencies—such as Standard and Poor’s, Fitch and Moody’s—to determine which bonds are investment-grade and which are junk. The Big Short is an excellent movie which examines the Credit Default Swaps over US mortgages leading into the 2008 financial crisis.
Currency Risk: The risk that assets held in another currency are negatively affected by the exposure to exchange rate movements. Foreign exchange risk (or exchange rate risk) applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you live in New Zealand and invest in a U.S. stock in USD, even if the share value appreciates, you may lose money if the USD depreciates in relation to the NZD. You can also consider investment options that (for a fee) hedge against adverse currency movements.
Derivatives Risk: Where financial derivatives are used as an alternative to directly owning or selling underlying assets in order to manage risk and/or enhance returns. Risks associated with derivatives can include – the value of the derivative declining to zero; the value of the derivative not moving in line with the underlying asset; the ability close out the derivative position or sell to another buyer. Also closely related to counterparty risk.
Emerging Markets Risk: Emerging Markets are generally less well regulated than their established counterparts. Funds investing in these markets can be susceptible to significant fluctuations in price. They may also present a currency risk (see above). They can carry additional risk in other areas including dealing, liquidity and taxation.
Fund Manager Risk: There is a possibility that the fund manager you invest with will underperform over an extended period of time. Large managers who run multiple strategies may also be exposed to corporate or broader reputational risk. This can be somewhat mitigated by diversification.
Hedging Risk: A technique designed to reduce the risk from part of an investment portfolio often by using derivatives. While hedging may reduce losses, it also has a cost and therefore may also reduce profits. Hedging is most commonly used to manage currency risk.
Inflation Risk: The risk that rising prices will erode the ‘real’ value or purchasing power of the cash held on deposit or the possibility that the return on your investments will not keep pace with inflation. For example, assets held in cash and some bond funds offer limited capital growth potential and an income not linked to inflation, thus inflation can affect both the value and income over time. If this happens, your ‘real wealth’ declines over time and you may not be able to meet your long-term income needs.
Interest Rate Risk: The risk that an investment’s value will change due to a change in the absolute level of interest rates, the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship. This type of risk affects the value of bonds more directly than stocks and is a significant risk to all bondholders. As interest rates rise, bond prices in the secondary market fall—and vice versa.
Leverage Risk: Leverage (debt or borrowing) amplifies the effect of changes in the price of an investment on the fund’s value. As such, leverage can enhance returns to shareholders but can also increase losses.
Liquidity Risk: The risk of not being able to access your funds when you need them (such as in an emergency). This can be split into two forms, market liquidity and funding risk. Market liquidity risk is the inability to trade an instrument at the desired price due to a lack of supply or market demand. Funding risk is where you have insufficient cash to meet your financial obligations. Typically, investors will require some premium for illiquid assets which compensates them for holding securities over time that cannot be easily liquidated.
Market Timing Risk: The possibility your investment may be sold at a time when the sale price is at a low-point or purchased when the sale price is at a high-point.
Opportunity cost: Not a directly linked risk, but the investment returns you may forego from an asset as a result of investing in your preferred asset. That is, there is a risk the preferred asset you invest in may not return more than the next best alternative asset you did not invest in.
Political Risk: Political risk is the risk an investment’s returns could suffer because of political instability or changes in a country. This type of risk can stem from a change in government, legislative bodies, other foreign policy makers, or military control. Also known as geopolitical risk, the risk becomes more of a factor as an investment’s time horizon gets longer.
Regulatory Risk: The potential that the government may change legislation in the future to the detriment of your investments. In many ways this is one of the hardest risks to manage and it is often best to consider the current environment.
Short Selling Risk: Funds may have exposure which involves short sales of securities. Short selling is designed to make a profit from falling prices or hedging a long position. However, if the value of the underlying investment increases, the short position will negatively affect the fund’s value.
Unlisted Asset Risk: It may be difficult or impossible to realise a direct investment because the underlying asset (typically property) may not be easily sold. The value of assets like property is a matter of a valuer’s opinion and the true value may not be recognised until the property is sold.
Read the full opinion piece “What investment risks to look out for”.
Source: adapted from Investopedia and CFA Institute.
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