8 types of investment risk

One of the major goals of a financial investment is to optimize returns. However, it is crucial to keep in mind the dimension of risk associated with it, as it can take on far more varied forms than you might imagine. myLIFE has developed a list of the main risks that could affect your investments, along with practical advice to address them.*

Investing inevitably involves risks, a fundamental aspect to consider before placing your money. The notion of risk is defined as the probability that the expected return of an investment differs from what it actually generates. It includes not only the likelihood of achieving gains lower than expected but also the possibility of incurring a partial or total loss of your capital. To illustrate this duality, imagine Russian roulette: although the chances of a positive outcome are relatively high, the consequences of failure are irreversible. Furthermore, it is essential to consider our risk tolerance, as it is not always easy to remain calm in the face of a market downturn, just as it is to resist the euphoria during periods of prosperity.

In theory, a higher potential yield comes with a greater risk. Conversely, a less risky investment will generally have more modest gains. Therefore, be cautious of risk-free investment offers promising high returns: they are often scams and, unfortunately, they proliferate on social networks in particular.

Various types of risks can influence the returns on your investments, depending on the financial instruments chosen and other factors. As an investor, you may be exposed to several major categories of risks that sometimes overlap in part**.

An investment may lose value due to factors affecting the entire market.

Market risks

> Systematic risks. An investment may lose value due to factors affecting the entire market: economic slowdown, interest rate fluctuations, price volatility, political decisions, etc.

> Geopolitical risk. It is linked to political and diplomatic events in one or several countries. Political decisions, government changes, conflicts, or international relations can thus influence the performance of an investment.

Specific risks

> Specific risks (or unsystematic risks) are associated with a particular asset, company, or industry sector. For example, a financial investment may be affected by economic difficulties of the company in which you have invested, by the lack of liquidity of an asset, by a regulatory change, etc.

Financial risks

> Interest rate risk. Changes in interest rates can impact the performance of your investments, especially those with fixed income, such as bonds. The value of a bond may decrease if interest rates rise, making new bonds more attractive. Moreover, the interest rate policies pursued by central banks have an impact on economic dynamics, and this impact influences the valuation of assets traded on financial markets.

> Exchange rate risk. By investing in a foreign currency, you expose yourself to fluctuations in the exchange rate. If the value of the currency in which you have invested decreases compared to the currency in your country, this decrease will negatively affect the return on your investment upon conversion.

> Credit and counterparty risk. This risk occurs when the issuer of a financial instrument (state, company, bank) fails to meet its payment obligations, leading to potential losses.

> Liquidity risk. Liquidity indicates how easily a financial instrument can be bought or sold on the market without affecting its value. In the case of low liquidity, it can be difficult to find a buyer at the desired price, which may force you to sell at a lower price.

Economic risks

> Inflation risk. Inflation refers to a general and sustained increase in prices over a given period. For fixed-rate investments, such as bonds, this can be problematic because their yield does not always follow the evolution of prices, thus degrading their real value.

> Macroeconomic risk. It reflects the influence of a country’s or region’s economic conditions on investments. The income generated by your investments can be influenced by economic growth, unemployment, inflation rate, etc.

Operational risk

This is the risk that a return may be affected by human error, system failure, or even fraud. This can be, for example, an error or delay in executing a transaction, software failure, a cyber-attack, etc.

Risks related to assets

> Equity risk. The stock price of a company constantly fluctuates up or down based on supply and demand. Therefore, there is a possibility of losing part of the invested funds between the time you purchase the asset and the time you resell it.

> Commodity risk. This risk is related to fluctuations in commodity prices in the market. If prices increase, it can reduce the profits of companies, thereby impacting their stock prices.

> Reinvestment risk. This risk refers to the possibility that the returns on an investment may not be as high as previously. When dividends or interest generated cannot be reinvested at competitive rates, it can make reinvestment unattractive, especially during periods of inflation.

> Business risk. This risk is linked to the financial health and performance of the company in which you have invested. Strategic choices, inefficient internal management, or a poor reputation can affect the return on your investment. In the event of bankruptcy, your investment may be completely lost.

We talk about concentration risk when all your capital is gathered in one type of investment. You then expose yourself to the uncertainties of a business or industry sector.

> Concentration risk. We talk about concentration risk when all your capital is gathered in one type of investment. You then expose yourself to the uncertainties of a business or industry sector. A single event can thus jeopardize a large part of the invested capital. It is to limit this risk that your banker encourages you to diversify your investments.

Legal and regulatory risks

Changes in the law or legislation of a business sector or legal disputes can influence the viability of a company and therefore the investments linked to it.

Risk associated with the investment horizon

Unexpected events (job loss, unforeseen work, etc.) may require changes to your investment horizon, leading to the premature liquidation of your investments, sometimes under unfavorable conditions.

Before you start, it is important to assess your risk tolerance. You need to know to what extent you are willing to put the invested capital at risk.

Can one protect oneself from the risks associated with investment?

While zero risk does not exist, some basic principles can be applied to limit your exposure and optimize your investments.

Define your investor profile: before you start, it is important to assess your risk tolerance. You need to know to what extent you are willing to put the invested capital at risk. Your profile will depend notably on the losses you are willing to accept, but also on your return objectives, your investment horizon, your financial capabilities, and your knowledge of the products. It will help you determine the type of investment that will suit you best, including your preferences for sustainable investments, and will allow you to sleep peacefully.

Inform yourself: it is advisable to learn about how markets operate and evolve, as well as the different types of assets you can invest in. This will allow you to better assess the risks and potential returns of your investment and help you make informed decisions.

Diversify your investments: do not put all your eggs in one basket! Spread your investments between secure and riskier options (see the principle of the investment pyramid). Also consider varying the sectors and geographical areas of the companies in your investment portfolio. This will allow you to balance your returns between losses and gains and generate consistent income.

Invest for the long term: with a long-term approach, especially for non-guaranteed return investments, you generally reduce risks, as investments are spread over periods of market ups and downs. You are more likely to offset potential losses and maximize your returns thanks to the principle of compound interest. Furthermore, do not engage in a race for returns, but invest according to your life goals.

Be consistent: It is difficult to predict the right time to invest. You might be tempted to wait for the best conditions to buy at the lowest price and sell at the highest. Do not fall for the illusion of being able to predict market movements (see the concept of market timing) and invest gradually, regularly, rather than placing all your money at once.

Stay rational: While you know in principle that you should avoid panicking in the face of stock price volatility or that it is wise to do your research before being seduced by the latest trendy assets, certain emotions can distort your judgment. Overconfidence, risk and loss aversion, confirmation bias, self-denigration, etc. Some cognitive biases can lead you to make bad decisions and harm your finances. Talk to your banker, they will help you keep a cool head.

You get the picture, if the main goal of an investment is to grow your capital, it also exposes you to a certain number of risks. If you are not comfortable with the idea of venturing into investment alone, do not hesitate to get support from an expert who can advise you based on your goals and profile.

* Content translated from French by the BIL GPT AI tool

** The list of risks presented in this article is not exhaustive.