Understanding Risk

Recognising Risk

What is risk?

Very few investments are risk-free. Investing in stocks, in particular, means accepting some level of risk. Risk is simply the probability of losing money on an investment. A more technical definition of risk is the volatility of return on the investment. An asset with erratic returns is considered to be riskier than an asset whose value stays rather static or moves slowly.

Risk and return

If you want to make a killing in the stock market, you are going to have to take risks. If you keep all your life savings in safe investments such as a savings account, you will face virtually no risk and have some peace of mind, but your return will be low and inflation will make your initial deposit less valuable over time. There is a trade-off between risk and return. Less risk means less return, while taking on more risk brings the possibility of a higher return.

How much risk can I take?

This depends on various personal factors.

  • Tolerance
    Ask yourself how much you are prepared to lose over one year without giving up on your investment.
  • Age
    Younger investors can usually afford to be more aggressive.
  • Investment goals
    If you are saving to buy a house or starting to invest for retirement, you will need to invest in growth stocks. This means taking on more risk.
  • Time horizon
    You should have a good idea of when you expect to cash in your investment. The longer you can afford to wait, the less risk is involved. Do not invest in risky assets if you may need funds in the short term.

Currency risk

If you invest in foreign investments that are denominated in foreign currency, you will also face currency risk.

The important thing to remember is that you can never consider foreign investments in isolation from their currency denomination.

Example of currency risk

Let us say you invested the equivalent of US$10,000 in a US stock and made a four percent gain in three months. You would be sitting on a paper profit of US$400. But if, for example, the US dollar declined by six percent in value relative to your domestic currency over the same period, the equivalent paper loss would be $600, leaving you with a net loss of $200.

Of course, it could just as easily happen that the US currency increases in value by the same amount over the same period, giving you a 10% net gain, or $1,000.

Balancing Risk

Types of risk

For higher investment yields you have to be prepared to take some kind of risk. In particular, you should be aware of two kinds of risk, Market risk and Unique risk.

Market risk

Have you ever noticed the way the values of individual stocks often tend to move in the same general direction as the overall market index? It is unusual for individual stocks to move markedly against the movement of the FTSE-100. This is because they are all driven by the same factors - inflation, interest rates, GNP figures - that affect the overall health of the economy. This is market risk.

Unique risk

Unique risk is specific to a particular stock.

Take, for example, DaimlerChrysler stock. Production disruption caused by a strike would be a source of unique risk in that it would only affect DaimlerChrysler.

Other sources of unique risk include:

  • Mistakes by company management
  • New inventions by a competing company
  • Lawsuits

Diversification

When you invest in the stock market you face both market risk and unique risk. The good news is that you can mitigate unique risk by taking a diversified approach to investing.

Diversification means spreading your money over a number of investments in order to reduce unique risks associated with individual investments. The more stocks you add to your portfolio (your collection of individual investments) the more unique risk you eliminate and the smoother your overall returns become.

Asset allocation

Unfortunately, diversifying your portfolio with more stocks will not eliminate market risk.

You can reduce this risk, however, by switching your money into less risky investments such as government bonds or savings bonds-but you will have to settle for lower returns.

Risk & Return

Types of risk

For higher investment yields you have to be prepared to take some kind of risk. In particular, you should be aware of two kinds of risk, Market risk and Unique risk.

Market risk

Have you ever noticed the way the values of individual stocks often tend to move in the same general direction as the overall market index? It is unusual for individual stocks to move markedly against the movement of the FTSE-100. This is because they are all driven by the same factors - inflation, interest rates, GNP figures - that affect the overall health of the economy. This is market risk.

Unique risk

Unique risk is specific to a particular stock.

Take, for example, DaimlerChrysler stock. Production disruption caused by a strike would be a source of unique risk in that it would only affect DaimlerChrysler.

Other sources of unique risk include:

  • Mistakes by company management
  • New inventions by a competing company
  • Lawsuits

Diversification

When you invest in the stock market you face both market risk and unique risk. The good news is that you can mitigate unique risk by taking a diversified approach to investing.

Diversification means spreading your money over a number of investments in order to reduce unique risks associated with individual investments. The more stocks you add to your portfolio (your collection of individual investments) the more unique risk you eliminate and the smoother your overall returns become.

Asset allocation

Unfortunately, diversifying your portfolio with more stocks will not eliminate market risk.

You can reduce this risk, however, by switching your money into less risky investments such as government bonds or savings bonds-but you will have to settle for lower returns.

Risk & Investment Types

All investments involve a degree of risk and returns can never be guaranteed so it is important to choose investments that suit your circumstances. Below is a quick-glance guide to a range of investment types and their associated risks.

Investment Type Objective Maximum Loss
Fixed Interest Bonds & Gilts Rising bond markets, fixed interest payments Initial Investment
Investment Trusts, Unit Trusts & ICVCs Rising investment prices, income from dividends Initial Investment
Exchange Traded Funds (ETFs) Rising index or sector prices Initial Investment
Irish, UK & International Stocks Rising share prices or dividends Initial Investment
Covered Warrants Rising or falling prices of the underlying financial investment Initial Investment
Company Warrants Rising or falling prices of the underlying financial investment Initial Investment