Why is risk important in investing?

Investing involves buying securities or other assets in the hopes that they will increase in value. This can produce a return on your investment. Generally, the higher the risk of an investment, the higher the potential return.

Risk and return are connected. It’s important to keep this in mind, because it means that investing returns are not guaranteed — it’s possible your investment could go up or down in value, sometimes on the same day. Pay attention to risk as well as return. If you focus only on achieving the highest possible return, you may not recognize the risk you are taking.

It’s important to understand your capacity to handle risk. This includes your ability and willingness to accept an investment outcome, even if it doesn’t produce the expected results. Find out more about risk tolerance.

What are the different types of investing risk?

There is more than one type of risk in investing, just as there is more than one type of investment. Some common risks include:

1. Horizon risk – The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. This may force you to sell investments that you were expecting to hold for the long term. If you must sell at a time when the markets are down, you may lose money.
2. Concentration risk – The risk that you might lose money because you’ve concentrated on a single investment or investment type. For example, investing all of your money in stocks in a single industry, rather than a portfolio of multiple types of investments. When you diversify your investments, you spread the risk over different types of investments, industries and geographic locations.

• Market risk – The risk of investments declining in value, because of events that affect the entire market. There are three types of market risk:
• Equity risk – Applies to investing in stocks or shares. Equity risk is the risk of loss because of a drop in the market price of shares. The market price of shares varies frequently depending on demand and supply.
• Interest rate risk – The risk of losing money because of a change in the interest rate. Interest rate risk applies to debt investments such as bonds. For example, if the interest rate goes up, the market value of bonds will drop. The value of real estate is also often affected by changes in interest rates.
• Currency risk – The risk of losing money because of a movement in the exchange rate. Currency risk applies when you own foreign investments. For example, if the U.S. dollar becomes less valuable relative to the Canadian dollar, your U.S. stocks will be worth less in Canadian dollars.

• Inflation risk – The risk of a loss because the value of your investments does not keep up with inflation. Inflation erodes the purchasing power of money over time — the same amount of money will buy fewer goods and services. Inflation risk is particularly relevant if you own cash or debt investments like bonds. . Investing in stocks is sometimes considered a hedge against inflation, since stock prices often rise in line with inflation over the long term. However, inflation can affect different stocks in different ways. The rising price of goods and services creates uncertainty in markets, which increases volatility and risk, which affects company profit and growth. Some shares may perform better when inflation is high, and others may not.
• Liquidity risk – This is the risk of being unable to sell your investment or get your money out when you want to. To sell the investment, you may need to accept a lower price than you’d prefer. In some cases, such as exempt market investments, it may not be possible to sell the investment at all.
• Credit risk – Credit risk applies to debt investments such as bonds. This is the risk that the government entity or company that issued the bond will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity. You can evaluate credit risk by looking at the credit rating of the bond. For example, bonds with a credit rating of AAA indicates the lowest possible credit risk.
• Reinvestment risk –This is the risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a bond paying 5%. Reinvestment risk will affect you if interest rates drop and you have to reinvest the regular interest payments at 4%. Reinvestment risk will also apply if the bond matures, and you have to reinvest the principal at less than 5%. Reinvestment risk will not apply if you intend to spend the regular interest payments or the principal at maturity.
• Longevity risk – This is the risk of outliving your financial savings. This risk is particularly relevant for people who are retired or are nearing retirement.
• Foreign investment risk –The risk of loss when investing in foreign countries. When you buy foreign investments, for example, the shares of companies in emerging markets, you face risks that do not exist in Canada.

How does risk affect your investing portfolio?

With most investments, there is a risk that your money could go up or down. Some investments, such as common shares, carry much greater risk. When you buy common shares, your return is uncertain — it will depend on the future price of the shares. There is a possibility that you will not get the return you are expecting or that you may lose money.

Risk can affect your investment return in many ways including:

• You own a diversified portfolio of shares with a value of $100,000. There is a market correction, and the value of your portfolio drops to $90,000. You have lost $10,000 as the result of equity risk.
• You own a diversified portfolio of bonds worth $100,000. The value of the portfolio drops to $95,000 because of an increase in interest rates. You have lost $5,000 as the result of interest rate risk.

Risk is usually perceived negatively as the potential to lose money. However, it can also have a positive side. For example:

• You own a corporate bond with a market price of $10,000. The company has become financially stronger over time and its credit rating is upgraded. As a result, the market price of the bond goes up to $10,500. You have made $500 as the result of accepting credit risk.

What does volatility have to do with investment risk?

How you handle market volatility is also worth considering. An investment’s volatility provides a good indication of the chance that it will lose money. When annual returns vary widely, there is more of a chance that the investment will lose money in any given year.

A stock price that changes quickly and by a lot is considered to be more volatile. This makes a stock riskier — you could lose a lot if you had to get your money out on short notice. The more an investment‘s price has varied from the average price, the greater its risk.

Consider this example of what volatility can look like in an investing portfolio:

• Tim and Marie both own diversified portfolios. Tim’s portfolio has an average annual return of 5%, but the actual return in a given year usually falls anywhere between -5% and 15%. Marie’s portfolio also has an average annual return of 5%, but the actual return in a given year usually falls anywhere between -10% and 20%. Marie’s returns are more volatile than Tim’s so her portfolio is riskier.

When you’re considering whether to buy an investment, it’s worth looking at its performance to see how much its value has gone up and down in previous years, and how quickly. While past performance isn’t necessarily an indicator of future performance, it’s helpful to consider how you would react if your investment were to perform similarly. This can tell you what your relationship to risk is like.

Learn more about how volatility affects your investments.

Remember: Every mutual fund provides a document called Fund Facts for investors. This includes the fund’s risk rating, based on the past volatility of the fund’s returns.

Is it possible to take too little risk in investing?

Because risk and reward tend to be connected, your potential returns will also relate to your level of risk tolerance. If you tend towards a lower risk tolerance, this means you may potentially have lower returns than what you need to achieve your objectives. If you don’t take enough risk, you may not make enough money to meet your investment goals.

For example, perhaps you decide you need an average annual return of 6% in order to meet your retirement savings goal. If you invest in low-risk investments that only pay 3%, you won’t meet your goal. If your goal was to retire comfortably, the lower return might mean that you need to delay retirement or accept a lower annual income in retirement.

It is difficult to avoid risk in investing. However, risk and returns are related, which means taking on some amount of investing risk can lead to potentially higher returns. How much risk you take on is an individual choice, based on your financial goals and personal situation. If you’re not sure  how to manage risk in investing, consider speaking with a financial advisor.

What’s your Investing Personality? Try this quick quiz to learn about how behavioural insights might help explain your investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition decisions.

Are there risk-free investments?

While there are no truly risk-free investments, the risk of loss with some investments is so small that it can usually be ignored. For example, Canadian treasury bills, a form of short-termTerm The period of time that a contract covers. Also, the period of time that an…+ read full definition government debtDebt Money that you have borrowed. You must repay the loan, with interest, by a set…+ read full definition, have very little risk of loss — the risk of the Canadian government going bankrupt over the investment term is very low. Because their risk is so low, treasury bills are virtually risk free. However, they also generally come with lower returns.