There are many types of investment risks, which include but are not limited to sector risks, business risk, liquidity risk, financial risk, tax risk and systemic risks such as political risk, market risk, interest rate risk and inflation risk. An investor usually needs to understand what is called risk-return tradeoff, which means that compensation for an investment is somewhat commensurate to the amount of risk assumed. That is, investments with a low chance of failure will likely yield low returns, and higher investment risks might generate superior returns. Thus, risk tolerance is typically at the forefront of many investors' minds before they make investments.
An investor who concentrates his or her portfolio in one sector, for instance, will likely face sector risks. Sector investment risks involve the chance of an event occurring that might adversely affect businesses in the same sector of the economy at the same time. For example, a major credit crisis might cause a decline in many stocks of companies that provide financial services.
Systemic risks, also referred to as systematic risks, are the kind of risks that affect an entire market or system. Economic crises, interest rates, political turmoil and other factors can cause systematic risks. Generally, systematic risks are not diversifiable risks. This means that even diversification might not help avoid these types of risks, so hedging is the usual way investors try to overcome systemic risks.
Essentially, investors use hedging strategies in an attempt to offset volatility by using instruments such as options or futures. For example, an investor who owns certain securities might have futures contracts to sell them at a particular price in the future. This way, even if these securities lose significant market value, he or she will be able to sell them at a specified price, which reduces risk — maybe even cancels it — and allows him or her to book a profit.
Furthermore, political risk is usually encountered in countries that have an unstable political environment. These countries can experience severe civil unrest, among other things, which can hurt many investments carried out there or those that are tied to these nations. Basically, price volatility is the daily price fluctuations of a market, which can sometimes overshoot in the wrong direction and can wipe out a good size of an investor's portfolio in the process.
Bond investors face interest rate risks. When interest rates rise, for example, the value of bond holdings can depreciate. Also, many fixed-income investment risks will be caused by a rising inflation, because this will make their values decline.
Liquidity risk can be faced, for example, when a market has no willing buyers, which can make it difficult for an investor to convert assets into cash at the time he or she desires. Moreover, active and/or leveraged stock trading carries higher investment risks that probably will not be suitable to many risk-averse people. This is because of the daily fluctuations of the stock market, which can sometimes be extreme. Risk-averse people will usually invest a greater portion of their funds in relatively low-risk investments, such as government bonds, insured savings accounts that produce low returns and so forth.
