Investing is one of the most effective ways to grow your money. However, it comes with its own share of opportunities and challenges alike. For better investment opportunities and to make informed investment decisions, it’s important to understand investment types and risks.
Being familiar with investment types and risks is important because no two investments are the same. Some investment assets offer high returns but may pose significant risk. Other investments, such as the low-risk investment, may offer more stability but lower returns. In this investment guide, we’ll discuss the common investment types and the risks attached to them, and how to manage these risks.
What is Investing and Investment Risk?
Investing can’t be separated from financial growth and stability, and it involves putting your money into assets with the goal of getting profits from them. Investment assets could be real estate, stocks, bonds, or cryptocurrencies. Unlike saving, which helps protect capital, investing involves some risks but with a higher return. Before you start investing, it is essential to understand the risks as well.
Investment risk is the possibility that a particular investment will not yield the expected return or that the value of the initial capital will decline. It’s more like an uncertainty of achieving your investment goal or losing part or all of your investment. Risks vary with investment type, and all investment types carry some form of risk, whether it is low-risk bonds or high-risk cryptocurrency investments.
Most of the time, high return potential often means significant investment risk. The degree of investment risk, however, depends on several factors, including the market itself, economic conditions, government regulations, and even global events. Understanding investment types and risks as an investor helps you make informed decisions while balancing risk and return.
Common Types of Investment
Investment comes in different types and forms. Here are some of the common types of investment and the risks associated with them:
1. Stocks
You’ve probably heard of stocks, as it is one of the popular investment types you will come across. Stock gives an investor partial ownership of the company in which they are invested. Likewise, investors benefit from stock investments through dividends from the company’s profits, capital appreciation, or both. However, stocks are a highly volatile investment, as they can rise during an economic boom and also fall during a stock market downturn.
Stocks like Apple and Tesla have offered massive returns over decades, but have also experienced significant losses. Stocks are for investors willing to take the long-term route while chasing better returns. However, risks like market risk can affect stocks, which is usually due to fluctuations in the overall market. No matter how solid a company is, if the entire stock market falls, it can result in a reduction in the price of stocks.
Another risk that affects stock is the currency risk, which majorly affects foreign investors. For instance, if a Nigerian investor buys US stocks and the value of the Naira decreases against the dollar, when their dollar investment is converted back to Naira, there may be an increase in their return. On the other hand, if the value of the naira increases, the returns from their investment will reduce.
2. Bonds
Think of a bond as lending your money out to either a government, municipality, or corporation in return for fixed interest payments. Although bonds seem safer than stocks and are an excellent addition to diversify your investment portfolio and grow your money , they are still exposed to risks. Government bonds, such as US Treasury bills, are considered more secure than corporate bonds, which carry a higher risk.
One of the major risk that affect bonds is the credit risk. This is the likelihood of incurring a loss due to a borrower or bond issuer failing to meet their repayment obligations. With credit risk, the investor or the lender might not be able to get their principal and interest. Corporate bonds, especially those from smaller or emerging companies, carry a higher credit risk compared to government bonds. Most of the time, credit risk becomes a reality when the company or entity in question faces financial difficulties and fails to make interest payments or even capital payments, leading to a significant loss for the investor.
Another risk that affects bonds is the Interest rate risk. It is simply the possibility for an investment interest to decrease in value due to changes in the market interest rates. Interest rate risk not only affects investments but also borrowing costs, which affect corporate profitability.
3. Cryptocurrencies
Cryptocurrencies are digital assets powered by blockchain technology, and popular options like Bitcoin and Ethereum have gathered huge returns over the years. Unlike traditional investment options, crypto is decentralised and can operate outside the control of the government. For a speculative investment like cryptocurrencies, significant risks are inevitable. It also comes with other concerns, such as security and regulatory uncertainty. While some investors have multiplied their wealth through crypto, others have lost considerable amounts in sudden crashes.
Currency risk, or exchange rate risk, is one of the risks that affects foreign assets like cryptocurrencies. When you invest in an international market and there’s a change in currency value, whether an increase or a decrease, it can affect your investment returns.
Laws, regulations, and government policies change over time and can impact investment vehicles. This type of investment risk is called the regulatory risk. Regulatory risk can arise from strict crypto regulations that impact the cryptocurrency market. These regulations can trigger market drops, and investors with investments in industries prone to heavy government oversight, such as crypto, healthcare, and banking, are particularly vulnerable to regulatory risk affecting their investments.
4. Real Estate and REITs
When you talk of real estate, you talk of lands and other landed properties. Real estate is not just about owning properties; it’s about making money from them through rental income and property appreciation. Unlike bonds and stocks, real estate is a tangible asset that can be developed, improved, rented, or sold. An example of real estate investment is owning an apartment building in a growing city, which provides steady income.
A Real Estate Investment Trust (REIT), on the other hand, is an indirect form of real estate investment and does not involve a physical property. Rather than dealing with the stress of owning and managing a physical property, you can invest in REITs instead. Through REITs, you can enjoy capital appreciation and high-yield dividends. Even though REIT is an indirect investment in real estate, it’s also prone to certain investment risks like physical properties.
Investing in real estate involves significant capital as well as maintenance costs, and is prone to liquidity risk. When it comes to liquidity, real estate might need time to bring in cash that is worth its value. This might take months or even years to sell, and if you’re to sell immediately, there’s a high tendency of selling below its worth.
5. Gold Bullion
Gold bullion is physical gold and is another way people invest and safeguard their money. It comes in different forms such as bars, coins, and ingots. Even though there are other forms of gold investment, people who want direct ownership of Gold often go for gold bullion.
However, gold bullion is often prone to low liquidity risk. This is because physical gold is difficult to convert into its cash equivalent and needs more time to sell. Since it can hardly be sold in a short time for its current worth, it is more suitable for a long-term investment goal. If the investor is forced to sell in a short time, it may be sold at a cash equivalent below its actual value, resulting in a financial loss.
6. Commodities
Commodities are tangible assets such as raw materials, like oil, natural gas, and agricultural products. Most of the time, commodities are used as a hedge against economic downturns and inflation. Commodities, however, can be influenced by factors such as supply and demand, as well as natural factors, including weather and climate.
Commodity risk comes into play when it comes to investment securities that include oil and agricultural products. The value of commodity investment is highly dependent on certain factors, such as the general global demand, weather conditions in terms of agriculture, and political instability in terms of oil and gas. All of these risks also apply to commodity funds, futures, and other assets related to commodities.
In addition, a commodity investment is also affected by inflation risk. In this regard, it could either be a positive or a negative risk. It could be a positive risk in the sense that, when there is an increase in inflation, your investment value increases as well. On the other hand, when there’s a deflation, the value of the investment diminishes as well.
7. ETFs
ETFs, short for Exchange-traded Funds, are investment funds that trade on stock exchanges just like individual stocks. This investment type tracks a group of assets, commodities, sectors, and indices. A good example of an ETF is the S&P 500 ETF, which allows investors to own a piece of the 500 largest companies in the US, all in one investment. Combining diversification and flexibility, ETFs are popular investment options for both beginners and experienced investors.
Just like stocks, ETFs are prone to market risk since their performance is tied to the index or market they track. Another risk is the trading risk, which is also tied to market volatility. This risk affects investors who trade multiple ETFs per day and not for the long run.
How to Manage Investment Risk
It’s one thing to understand the various investment types and associated risk; it’s another thing to know how to manage the risk. The following are ways to manage investment risk and prevent significant investment loss.
1. Risk Assessment
One financial mistake to avoid is investing without assessing potential risks. Before investing your money, one of the first things you must do is understand your own risk tolerance. Properly assessing risk, depending on the investment type, can help reduce the severity of an investment loss. Risk assessment involves evaluating how much financial and emotional loss you can withstand without making decisions that could negatively impact your investment.
For instance, a young investor in their 20s with a stable income may have a higher risk tolerance than someone about to retire. By weighing factors such as income, duration to retirement, financial goals, and risk tolerance, you can know the best investment to go for.
2. Diversification
One important strategy in reducing investment risk is by diversifying your portfolio. Diversification means spreading your investment across various asset classes, including stocks, bonds, ETFs, cryptocurrencies, and others.
In a situation where one investment performs poorly, diversification allows the better-performing investments to offset the poor-performing one. Overall, diversification reduces the impact of market investment risk while offering stability.
3. Asset Allocation
One strategy that is fundamental to mitigating portfolio risk while maximising return is asset allocation. Asset allocation works well with diversification, but focuses on how much money you put into different asset classes. To make this work, you need to carefully select and balance different asset classes when creating an investment portfolio that can withstand market volatility and other investment risks.
You can use the investment risk pyramid strategy to allocate your assets, whereby you place low-risk assets like bonds at the bottom of the pyramid while high-risk investments like stocks are placed on top. An example of an investment allocation is the 60/40 portfolio, where 60% of the investment is allocated to stocks and 40% to bonds. When distributing your assets, it should not be done randomly. Instead, it should be done based on your goals, risk appetite, and time horizon.
4. Consider Dollar Cost Averaging
Investing a certain amount of money at regular intervals, regardless of market conditions, is known as dollar-cost averaging (DCA). Rather than trying to time the market, you can buy more shares during a fall in the price of stocks. This lessens the impact of market volatility over time and lowers the average cost of your investments. If you’re considering long-term investment goals, then dollar-cost averaging is an investment risk-mitigating strategy worth considering.
Conclusion
Investing is one way to build wealth, but it comes with major concerns that every investor must understand and manage. Exploring various investment types and risks can help you choose the right investments. While some investments are low-risk, some are high-risk. Avoiding investment is not the point, but managing the risk that comes with it wisely. Through thorough risk assessment, diversification, and proper asset allocation, you can maintain a balanced approach between risk and profit.
