01^st January, 2021 by elmads

Investing has been gaining popularity in this day and age, we keep on hearing and seeing posts on various social media platforms about this. In particular, people posting on how large their money grew in just a day or a week, how quickly they got a lot of money, or how they retired early by just investing. Nevertheless, these claims should always be taken with a grain of salt, as investing can also be the cause of our financial ruin due to various risks we have in the investing world.

 I am not here to discredit these people, what they claim can definitely happen, only when done right with consistency, knowledge and discipline. Just like in the jobs and professions that people do, we attain proficiency and mastery in our craft because we have studied and applied the knowledge attained, which mitigates the risks of committing errors in our chosen field. Take for example surgeons, they reduce the risk of committing mistake by acquiring the basic to advance knowledge about their craft, which also gives them the confidence to do surgical operations, same as for lawyers who defends either the plaintiff or the defendant, priests who preaches the word of God and many more.

This holds true with investing as well. Knowing what are the risk factors that can derail our investment journey and financial goals will immensely help us investors to make a sound, calm and realistic decisions about our investments.

Every saving and investment instruments have their own risks. We need to ask the questions to ourselves, such as; can we obtain the money needed as soon as possible, the speed in which the money grows, and how safe our money is with this specific investment. All of these can be answered by knowing the 5 basic risks of investing which we investors will always face. These are the company risk, volatility, liquidity, interest rate and inflation.

Company / Market Risk

If we are invested in stocks that means we have a piece of ownership of a company. While, when we are invested in a corporate bond it denotes that we gave a loan to a specific company. Both are ways of investing in a company and both of these investments are dependent on the company’s future growth and stability. If the company goes to bankruptcy, then our invested money could either be returned, but just in a very small portion of what it was or in worst case scenario we might not even receive back the money we have invested. To illustrate, Eastman Kodak company filed bankruptcy in January 2012 because the company had been declining as they have not shifted quickly with the changes of times, which is the digitization age. Kodak’s company performance had been clearly reflected with its stock market price as shown below from 1978 to 2010.

In addition, lawsuits, fraud, employment problems, and business model risks can also impact the company’s overall performance in the short to long term horizon, both in the business operation front and the stock market price. Take for example, Facebook’s lawsuit regarding the Cambridge Analytica scandal in 2018, in which millions of Facebook users’ personal data was acquired without the individuals’ consent by Cambridge Analytica, predominantly to be used for political advertising. Facebook’s market price plunged from 185 USD to 152 USD which is around 17% stock market price drop. If you bought let’s say 1 million worth of Facebook stock when it was 185 USD per share, then you have lost 170,000 thousand only by paper. It will be actual lost if you really sold it at that amount which is a big mistake.

Without knowing what the company does, how they operate, how they make money, what are their other businesses and how is their financial statement, will surely cause investors to sell their position in Facebook that time in 2018. Just like what I have told you a while ago, not knowing what we are investing in causes investors to panic more, hence selling their stock positions that time. Those who bought more of the stock during that drop has certainly reaped the benefits of the gains that they are experiencing now, because the price of Facebook stock as of 01/01/2021 is at 273.16 USD per share.

Volatility Risk

Volatility is the fluctuation of the stock market price either up or down, and the frequency of its changes. Some companies have high volatility whereas others have low. Volatility is predicated to both individual and institutional investors (investors with a large sum of money, at a minimum of millions) who buys and sells stocks. When a company has not met the expectation of the investors, it can cause rapid sell off of its stock market price. Such volatility is caused by the following, when earnings are not met by the company in a single quarter or a year, faulty product, political risks or market events like recessions.

Stable and large companies have usually lower volatility due to their profitability whereas small companies have higher volatility due to more uncertain business environment and higher competition.

As shown in the chart above, Disney a stable entertainment company has been seeing volatility through out the years, but the general market trend has been positive, whereas Novovax Inc a small pharmaceutical company has been very volatile for more than 2 decades already due to high competition in its healthcare pharmaceutical industry.

Volatility is a friend for investors as it gives the chance for them to buy at a lower price range. This is true as well for traders.

Liquidity Risk

It is the easiness that an asset can be converted into cash quickly. Cash is the most liquid asset, as it is universally trusted way of transacting and trading for goods and services. Contrary to that, are illiquid assets that are not easily traded into cash, these are assets that usually take months or even years before it can be sold, like real estate assets. US dollars is the most widely trusted currency cash that is being used for transactions worldwide.

Liquidity risks are mitigated by knowing what are the liquid and illiquid assets and how to utilize it, this depends on our time horizon before needing to spend the money. As case in point, if we are investing for our retirement and we still have 20-30 years worth of investing, then placing our hard- earned money in illiquid assets like stocks and real estate are good asset classes to utilize. These two are for long-term investment strategy, as we will not need the money any time soon. On the flip side, if we need the money for less than a year, then it is prudent to place our money into money market accounts such as flexible savings account, which is one of the most liquid assets that we can invest in.

Interest Rate Risk

Interest rates are dependent on the central banks of each country. They are the banks responsible to support their country’s economy. They are the only one who can print more money to support the economy when the country is in crisis. Or, they will increase interest rates to reduce the rate of spending of their people in order to lessen the scale of obtaining debt/loan to the banks, this is only done when the economy is doing good than it should be.

Central bank interest rates affect savings account rates, loan rates and bond rates as well. When Central bank interest rates are set high, it is automatically expected that both savings accounts and loan rates from banks will be high too, same effect will happen when the interest rates are low. Furthermore, rising interest rates will yield high returns with bonds, whereas falling rates will yield less returns from bonds, I have discussed this further on by blog titled “Bonds”. To give you context, in the year 2020, the Central bank interest rates in both the US and the UK are at 0.10% this give 10 year bonds a yield return of equal or less than 1-2%, which makes it very unattractive for investors. That is why most investors flocked into stocks as it gives higher return than bonds due to the decreasing interest rate environment. This causes the stock market prices to go higher, reaching very high price levels.

Central Bank interest rates are a complex topic, as it directly has an effect not only in the marketable securities (like stocks and bonds), but also in the economy.

Inflation Rate Risk

Inflation is the consistent increase of the price of products and services, basically due to the increase of demand, and/or increase in production costs of goods and services, such as raw materials and employee wages. I have quickly discussed this in my blog titled “Why should you save and invest your hard-earned money”.

Purchasing power decreases because of inflation, that is why investing into various asset classes mitigate this risks. I have blog in which I discussed the asset classes titled “The 5 Basic Asset Classes”.

To sum it up

Risk cannot ever be removed from the equation of choices and decision making, as there is no such thing as 0% risk. Even in our daily lives, the risk of having accidents when going to work either driving, walking, utilizing public transport, or committing mistakes at home or at work cannot be taken away, but it can certainly be reduced. For instance, when driving, we can always follow the traffic regulations, and at work we must not do shortcuts in order to reduce the risk of error. Taking the steps into learning what are the risks and knowing how to manage it can be the big difference of attaining either unhappiness or fulfilment in life, and financial ruin or independence.

“Managing risk is very different from managing strategy. Risk management focuses on the negative-threats and failures rather than opportunities and successes.”

-Robert S. Kaplan

Knowledge is my Sword and Patience is my Shield,

Evan Louise Madriñan / elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.