You know that investing comes along with certain risks. But you may have not thought those through. What are the main risks of investing in financial assets? And what are possible mitigation measures? In this entry we’ll cover the main risks you should look out for.
Setting the scene
What are financial assets?
Financial assets are assets that get their value through a contractual right or ownership claim [1]. They’re non-physical assets. Stocks, bonds and funds are examples of financial assets. A house isn’t a financial asset.
Defining ‘risk’
In the context of financial assets, risk is the chance that the outcome of our investments differs from our expectations.
Depending on where you’re from, the meaning of the word risk varies. in some countries, it has a neutral meaning (as in uncertainty). In others, it’s negative (as in threat). In this entry, we’ll treat risks as something negative. So, in the definition above, we can read “[…] differs from our expectations” as “[…] is lower than our expectations”.
The types of financial asset risks
There are countless types of financial asset risks. In this entry, we’ll focus on what I consider the main ones.
To do so, we’ll follow the typical journey one follows when investing in financial assets. This journey has three steps. First, you devise an investment strategy. Then you find an open an account with a broker. Finally, you buy and hold securities.
A typical mistake is to just consider risk belonging to the final stage. Many associate investing risk with market crashes. And just with market crashes. In reality, though, there are risks associated with each step of the journey. With that in mind, the rest of this entry covers:
- Investment strategy risks
- Broker risks
- Financial market risks
1. Investment strategy risks
Investment strategy risks are those associated with your overall investment decisions. They might shape up before you actually buy a single financial asset.
Horizon risk
Horizon risk is the chance of your investment horizon being shortened because of an unforeseen event. We talked about it here. Be conservative with your investment decisions and never invest in risky assets with money you might need in the short term.
Concentration risk
Concentration risk is the potential for a single investment to cause a major value loss in your portfolio [2]. For example, you may only invest in US equities. But if US underperforms the world for a long time, you’ll suffer a major blow.
An even more common example (although not in the realm of financial assets) are houses. It’s normal for many to concentrate all their wealth to buy a primary residence. Any uninsured big loss can result in disaster.
The mitigation strategy for concentration risks is well-known: diversify.
Leverage risk
Leverage means to (partially) fund investments with debt. This amplifies returns, both positive and negative. Leverage risk is the potential for amplified losses.
In general, the average investor should stay away from leveraged investments in financial assets. That said, leverage is common for physical assets. Examples are buying a house or a car with a loan (e.g. mortgage).
2. Broker risks
Brokers are intermediaries in the investing process. You need them to gain access to centralized exchanges. But they also cut a fee and introduce additional risks.
In my opinion, broker risks are the most unlikely of the three categories in this entry. This is maybe because there aren’t so many actual cases when any of the risks below has materialized. At least not at scale. That doesn’t mean they’re unimportant, though.
Risk of broker’s bankruptcy
Your assets are stored with a broker. What happens if the broker goes bankrupt? Nothing bad. At least in theory.
In general, any customer assets aren’t part of a broker’s balance sheet. They’re kept separate. Even if a broker goes bankrupt, your money can’t be used to pay any shareholders or debt collectors. Besides, there’s yet another line of defense set by financial regulators. Deposits and / or securities are typically insured up to a certain amount. For Swiss brokers, it seems to be CHF 100k.
That’s the theory. I’m no expert in this area, but reality can surely get much more complex. Even if you’re entitled to recover your assets, it could take months or even years for the mess to clear out.
If you want to mitigate this risk, you may do research on which jurisdictions offer the highest protection. If you choose a broker this way, it might come at the expense of paying higher brokerage fees or not having access to certain products (e.g. US domiciled funds).
Compliance risk
Compliance risk is the possibility of having your funds locked away due to failure to meet regulatory obligations. Imagine one day your broker flags your account as a possible case of tax fraud. It might be a random check, but it might as well be a false lead that takes months or years to get solved. You wouldn’t have access to your assets in the meantime. You can’t easily mitigate this risk.
Hacking risk
Hacking risk is the risk of a third party gaining access to your account and taking control of your positions. Most brokers won’t help you if this happens. From example, this is an extract from Interactive Brokers Customer Agreement:
Customer is responsible for the confidentiality and use of Customer’s user name / password. […] Customer remains responsible for all transactions entered using Customer’s user name/password[…]
Like with any credentials-based online system, nothing makes you 100 percent safe. But using two-factor authentication is a good mitigation measure.
A broader interpretation of hacking risks could also include the risk of data vanishing. Imagine any records of any customer ever having an account with your broker just disappear. This would be a black swan event. Something without precedent at the time of writing. But still not impossible. Like before, there’s no easy mitigation for this risk.
3. Financial market risks
Financial market risks is a broad category to encompass all risks that result in an investment performing poorly.
Market risk (systematic risk)
Market risk is the potential for an investor to incur losses due to factors that affect the overall performance of markets [3]. Examples are natural disasters, terrorist attacks, recessions or political instability. Because such events can have a global reach, market risk can’t be eliminated through diversification.
Market risk is probably the main risk new investors have in mind. When you invest, you know that it’s possible to lose money for reasons beyond your control. This is, in a nutshell, market risk.
There’s still ways to hedge yourself against market risk. At least partially. For example, you can use insurance or derivatives to hedge against natural catastrophes. But most of such solutions are exotic and relatively uncommon.
Non-systematic risk
Non-systematic risk is the possibility of an investor experiencing losses due to factors that affect a company or industry [4]. The main difference with market risk is that non-systematic risk can be diversified away. For example, airlines took a big hit during the COVID-19 lockdown. But other sectors (e.g. tech) did well.
Non-systematic risk is somewhat linked to concentration risk. It can be mitigated by defining the right investment strategy.
Foreign exchange risk
Foreign exchange (FX) risk is the risk of a value loss of your foreign assets in your domestic currency due to FX fluctuations. We talked about it in detailed in this entry.
The ultimate mitigation measure is to buy assets with cash flows that are bound just to your local currency. Examples are domestic real estate or bonds. This in turn risks foregoing more attractive long-term return of other asset classes, such as equities. For equities, FX risk can’t be eliminated because big companies earn revenues in multiple currencies.
Interest rate risks
Interest rate risk is the potential change in value of your assets when interest rates change. We discussed its effect on bonds (most patent example) in this entry. Other asset classes (e.g. equities) are exposed as well.
Interest rate derivatives (e.g. swaps or options) can be used to hedge this risk. This is however out of reach for an average retail investors.
Credit risk
Credit risk is the probability of a loss from a borrower’s failure to repay his debt. We also discussed it in detail in this entry. The main mitigation measure are buying higher quality debt instruments. Derivatives (e.g. credit default swaps) are also an option for sophisticated investors.
Liquidity risk
Liquidity risk is the chance of not being able to buy or sell a financial asset quickly enough. This risk is rather minimal for financial assets that trade on an exchange. For other financial assets that trade through dealers (e.g. individual bonds) or for physical asset (e.g. real estate), this risk can be critical.
Inflation risk
Inflation risk is the possibility that inflation will undermine your investment returns. Fixed income assets (e.g. bonds) are typically the most exposed to this. Equities are somewhat hedged, because company revenues raise as well with inflation.
A classic way to hedge against inflation is to buy inflation-protected bonds such as TIPS.
Other financial market risks
We’ve covered some of the main types of financial market risks. But there’s many more out there. You can find other risks here [5, 6, 7].
What you’ve learned
You knew before opening this entry that there are some risks associated with investing. Hopefully this read has given some structure to your thinking. We’ve seen risks associated with:
- Your investment strategy
- Brokers
- Financial markets
You’ll never manage to mitigate or hedge all risks mentioned in this entry. If you want to invest, you’ll have to learn to simply accept many of them.
Some risks, however, are worth keeping in check. Risks associated with your investment strategy are probably the ones you can influence the most. Non-systematic risk also belongs to that category.
Last updated on June 28, 2020