Skip to main content
diversification.com
← Back to I Definitions

Investment risks

What Are Investment Risks?

Investment risks refer to the possibility that an investment's actual return will differ from its expected return, potentially leading to a loss of principal or a lower-than-anticipated gain. These risks are a central concept within Portfolio Theory, influencing all aspects of investment decision-making. Understanding investment risks is crucial for investors and financial professionals to make informed choices, manage expectations, and construct resilient portfolios. The degree of investment risks an asset carries is a primary determinant of its potential returns; generally, higher potential returns are associated with higher levels of risk.

History and Origin

The concept of investment risks has evolved with financial markets themselves. Early investors recognized the inherent uncertainty in ventures, but the systematic study and quantification of risk gained prominence in the 20th century. Major market events, such as the Great Depression, underscored the need to understand and mitigate significant financial exposures. Later, the development of Modern Portfolio Theory by Harry Markowitz in the 1950s provided a mathematical framework for analyzing risk and return, fundamentally changing how investment professionals approached asset allocation.

More recently, global events have highlighted the interconnectedness and varied nature of investment risks. The global banking crisis of 2008, for instance, exposed profound vulnerabilities within the financial system, emphasizing the importance of robust Risk management practices across institutions. The Senior Supervisors Group, in a report following the crisis, noted critical areas of risk management practice that required improvement across the financial services industry, particularly regarding funding and liquidity issues.4

Key Takeaways

  • Investment risks encompass various factors that can cause an investment to lose value or underperform expectations.
  • These risks can be broadly categorized into Systematic risk (market-wide) and Nonsystematic risk (specific to an asset or industry).
  • Quantifying investment risks often involves statistical measures like standard deviation, which indicates an investment's historical Volatility.
  • Effective management of investment risks is central to achieving long-term financial objectives and involves diversification, asset allocation, and continuous monitoring.

Formula and Calculation

While there isn't a single universal "formula" for overall investment risks, various metrics are used to quantify different facets of risk. One common statistical measure for historical investment risks, specifically volatility, is standard deviation. Standard deviation measures the dispersion of an investment's returns around its average return. A higher standard deviation indicates greater historical volatility and thus, typically, higher perceived investment risks.

The formula for the standard deviation of historical returns is:

σ=∑i=1N(Ri−Rˉ)2N−1\sigma = \sqrt{\frac{\sum_{i=1}^{N} (R_i - \bar{R})^2}{N-1}}

Where:

  • (\sigma) = Standard Deviation (volatility)
  • (R_i) = Individual return in the data set
  • (\bar{R}) = Average return of the data set
  • (N) = Number of returns in the data set

This calculation provides a quantitative measure that can be compared across different investments to assess their relative investment risks.

Interpreting Investment Risks

Interpreting investment risks involves more than just looking at numbers; it requires understanding the context of an investment and its place within a broader portfolio. A high standard deviation, for example, signals that an investment's returns have historically fluctuated widely, suggesting higher price volatility. However, this doesn't automatically mean it's a "bad" investment. It simply means it carries greater Market risk and potential for both significant gains and losses.

Investors typically assess investment risks in relation to their personal financial goals, time horizon, and Risk management tolerance. For instance, a young investor with a long time horizon might be comfortable with higher investment risks in pursuit of greater long-term growth, while a retiree might prioritize stability and lower risk. Beyond volatility, investors also consider qualitative factors such as the strength of a company's management, industry trends, and geopolitical stability, all of which contribute to the overall investment risks.

Hypothetical Example

Consider an investor, Sarah, who is evaluating two hypothetical exchange-traded funds (ETFs): ETF A and ETF B. Both ETFs have delivered an average annual return of 8% over the past five years.

  • ETF A: Historically, ETF A's annual returns have been: 15%, 10%, 5%, 8%, 2%.
  • ETF B: Historically, ETF B's annual returns have been: 9%, 8%, 7%, 8%, 8%.

To assess the investment risks based on historical volatility, Sarah calculates the standard deviation for both.

For ETF A:

  • Average return ((\bar{R})) = (15+10+5+8+2)/5 = 8%
  • Sum of squared differences from the mean:
    • ((15-8)^2 = 49)
    • ((10-8)^2 = 4)
    • ((5-8)^2 = 9)
    • ((8-8)^2 = 0)
    • ((2-8)^2 = 36)
  • Sum = 49 + 4 + 9 + 0 + 36 = 98
  • Standard Deviation ((\sigma_A)) = (\sqrt{\frac{98}{5-1}} = \sqrt{\frac{98}{4}} = \sqrt{24.5} \approx 4.95%)

For ETF B:

  • Average return ((\bar{R})) = (9+8+7+8+8)/5 = 8%
  • Sum of squared differences from the mean:
    • ((9-8)^2 = 1)
    • ((8-8)^2 = 0)
    • ((7-8)^2 = 1)
    • ((8-8)^2 = 0)
    • ((8-8)^2 = 0)
  • Sum = 1 + 0 + 1 + 0 + 0 = 2
  • Standard Deviation ((\sigma_B)) = (\sqrt{\frac{2}{5-1}} = \sqrt{\frac{2}{4}} = \sqrt{0.5} \approx 0.71%)

Even though both ETFs have the same average return, ETF A has a significantly higher standard deviation (4.95%) compared to ETF B (0.71%). This indicates that ETF A carries higher investment risks in terms of price volatility. Sarah can use this information to decide if the greater fluctuation of ETF A aligns with her comfort level for Volatility.

Practical Applications

Understanding and managing investment risks are fundamental across various financial disciplines. In Portfolio management, identifying and quantifying different types of investment risks is critical for constructing portfolios that align with an investor's objectives and risk tolerance. This often involves strategic Asset allocation to balance various risk exposures.

For instance, investors frequently face Inflation risk, where the purchasing power of their returns diminishes over time, or Interest rate risk, which affects the value of fixed-income securities. Furthermore, individual companies contend with Operational risk related to their business processes and Credit risk when lending or extending credit. Regulators, such as the U.S. Securities and Exchange Commission (SEC), also focus on investment risks. The SEC's Division of Investment Management, for example, reviews fund filings with a particular focus on risk disclosures to enhance investor protection and facilitate informed investment decisions, including those related to investments in emerging markets.3 Recent market shifts, like those impacted by tariffs and global trade uncertainties, also highlight how broad economic factors create significant investment risks that require constant assessment.2

Limitations and Criticisms

While frameworks for assessing investment risks are robust, they are not without limitations. A primary criticism is the reliance on historical data to predict future performance. Past volatility, while informative, does not guarantee future results, and unforeseen events can introduce new, unpredictable investment risks. Models often struggle to capture "tail risks" or extreme, low-probability events that can have disproportionately large impacts. For example, research from the Federal Reserve has explored "Inflation-at-Risk" measures, highlighting how macroeconomic drivers affect the predictive inflation distribution and the probability of inflation running above or below certain thresholds, acknowledging the inherent difficulty in forecasting such tail events.1

Furthermore, the quantification of certain subjective investment risks, such as Regulatory risk or geopolitical instability, remains challenging and often relies on qualitative assessments rather than precise formulas. Oversimplification of complex market dynamics into a single risk measure can also lead to a false sense of security or overlook critical underlying vulnerabilities. While tools and models help mitigate investment risks, they do not eliminate them, nor do they perfectly predict all potential pitfalls.

Investment Risks vs. Risk Management

Investment risks and Risk management are distinct but intrinsically linked concepts. Investment risks refer to the inherent uncertainties and potential for negative outcomes associated with an investment. These are the "what-ifs" – the possibilities of losing money due to market fluctuations, inflation, or a company's poor performance. They are external forces or inherent characteristics of an asset or market that create exposure to loss.

In contrast, risk management is the systematic process of identifying, assessing, and mitigating these investment risks. It involves the strategies, techniques, and policies employed by investors and institutions to understand, measure, and control their exposure to various risks. This includes practices like Diversification (spreading investments across different assets to reduce concentration risk), hedging, setting stop-loss orders, and conducting thorough due diligence. While investment risks exist independently, effective risk management aims to minimize their potential negative impact on a portfolio.

FAQs

What are the main types of investment risks?

Investment risks generally fall into two broad categories: systematic risk and nonsystematic risk. Systematic risk, also known as Market risk, affects all investments, such as Inflation risk or changes in interest rates. Nonsystematic risk is specific to a particular company, industry, or asset, like Operational risk or the risk of a new competitor.

How can I measure investment risks?

Investment risks can be measured using various quantitative tools, with standard deviation being a common measure of historical Volatility. Other metrics include Beta, which assesses an asset's sensitivity to market movements, and Value at Risk (VaR), which estimates potential losses over a specific period. These measures help quantify the degree of investment risks an asset or portfolio might entail.

Can investment risks be eliminated?

No, investment risks cannot be entirely eliminated. Every investment carries some degree of risk, even seemingly "safe" ones. However, investment risks can be managed and mitigated through strategies like Diversification, proper Asset allocation, and continuous monitoring of market conditions and individual holdings.

What is the relationship between risk and return?

The relationship between risk and return in investing is generally positive: higher potential returns typically come with higher investment risks, and lower risks are usually associated with lower potential returns. This is often referred to as the "risk-return trade-off." Investors must decide how much risk they are willing to undertake to achieve their desired returns.