Investing in financial markets is inherently accompanied by a variety of risks, each with its own characteristics and implications. Understanding these risks is crucial for making informed investment decisions and effectively managing a portfolio. Here are the primary types of investment risk:

Market Risk

This is the risk of investments declining in value due to economic developments or other events that affect the entire market. Market risk is also known as systematic risk and cannot be eliminated through diversification. It includes equity risk, interest rate risk, and currency risk.

Imagine you invested in the stock market by purchasing shares of a major technology company. Everything is going well, and the stock price is steadily increasing. However, suddenly, there’s a significant economic downturn or a global event, such as a financial crisis or a pandemic. As a result, the entire stock market experiences a sharp decline, including the shares of the technology company you invested in.

In this situation, even though the company itself might still be performing well, the broader market conditions have caused its stock price to drop significantly. This is an example of market risk—where the value of your investment is impacted by events that affect the overall market, rather than the specific performance of the company.

Market risk is often beyond the control of individual investors, which is why it’s important to diversify investments and stay informed about global economic trends and events.

Credit Risk

Also known as default risk, this refers to the possibility that a borrower (for example, individuals, businesses, and governments) will fail to meet their obligations in terms of payments. Credit risk is a major concern for investors in bonds or other debt instruments.

Imagine you, as a retail investor, decide to invest in corporate bonds issued by a company. You’re attracted to these bonds because they offer higher interest rates compared to government bonds. However, there’s a risk that the company might face financial difficulties and be unable to pay back the principal amount (your invested amount) or the interest on the bonds. This is known as credit risk. For instance, during the financial crisis of 2008, many companies struggled to meet

their debt obligations, and some even defaulted on their bonds, leading to significant losses for investors who held those bonds.

To mitigate this risk, investors often look at credit ratings provided by agencies like Moody’s, Standard & Poor’s (S&P), and Fitch. These ratings give an indication of the company’s creditworthiness and the likelihood of default. For example, a bond with a rating of AAA is considered very safe, while a bond with a rating of BBB or lower is seen as riskier.

By keeping an eye on these ratings and the financial health of the issuing company, you can better manage exposure to credit risk.

Liquidity Risk

Imagine you own a rare, valuable painting worth €10,000. You bought it as an investment, hoping its value would increase over time. However, you find yourself in urgent need of cash and decide to sell the painting. The problem is, finding a buyer who is willing to pay the full value of €10,000 quickly isn’t easy. You might have to settle for a lower price, say €7,000, to sell it faster. This situation illustrates liquidity risk—the risk that you can’t easily convert your investment into cash without losing value.

In the financial markets, this risk is also present with certain investments like real estate, less-traded stocks, or specific bonds. These assets might be harder to sell quickly without accepting a lower price, especially during market downturns when fewer buyers are available.

For retail investors, it’s important to be aware of liquidity risk and consider it when choosing investments. Balancing your portfolio with a mix of highly liquid assets (like cash or highly traded stocks) and less liquid assets can help manage this risk.

Inflation Risk

Also known as purchasing power risk, this is the risk that the value of an investment’s returns will be cancelled out by inflation. For example, imagine you have €10, and today you can buy 10 candies with that money because each candy costs €1. But what if, next year, the price of each candy goes up to €1.10? Now, your €10 can only buy about 9 candies.

Inflation risk is particularly relevant for fixed-income investments such as bonds, where the returns are fixed and do not increase with inflation, and cash holdings.

Currency Risk

This is the risk of losing money due to changes in exchange rates. International investments are subject to this risk. If the value of the foreign currency drops, so does the value of your investment.

Imagine you are a retail investor in Germany, and you decide to invest in a U.S. company by purchasing its stocks. You use euros (EUR) to buy U.S. dollars (USD) to make the investment. At the time of your investment, the exchange rate is 1 EUR = 1.10 USD. You invest €10,000, which gives you $11,000 to buy stocks.

Now, let’s say after a year, the value of the U.S. company stocks has increased by 10%, so your investment is now worth $12,100. However, during the same period, the exchange rate changes to 1 EUR = 1.20 USD because the value of the USD has decreased relative to the EUR.

To convert your $12,100 back to euros, you now divide by the new exchange rate:

Value in EUR = 12,100/1.20 ≈ 10,083  EUR

Even though your investment in the U.S. company stocks has grown, the depreciation of the USD means that when you convert back to euros, you only get approximately €10,083. This means your profit is much smaller than expected, illustrating how currency risk can impact your returns.

Interest Rate Risk

This is the risk that changes in interest rates will affect the value of an investment. If interest rates fall, the value of existing bonds usually goes up. However, when interest rates rise, the value of existing bonds typically falls because new bonds are being issued with higher interest rates, making the older, lower-rate bonds less attractive. Interest rate risk is most significant for bond investors.

Who influences the interest rate?

• Central Banks: Central banks, like the European Central Bank (ECB) or the Federal Reserve in the United States, play a crucial role in setting key interest rates. They adjust these rates to control inflation, manage economic growth, and stabilize the currency. For instance, raising interest rates can help cool down an overheating economy and combat inflation, while lowering rates can stimulate borrowing and spending during economic slowdowns.
• Market Forces: Supply and demand in the financial markets also affect interest rates. When many people want to borrow money, or when there is a lot of lending, interest rates can rise. Conversely, if there is less borrowing or more lending money available, interest rates might fall.
• Government Policies: Government spending and taxation decisions can influence interest rates indirectly. For example, if a government is having a lack of budget, it may borrow more, which can push up interest rates.
• Global Economic Conditions: International economic events and trends can impact domestic interest rates. For example, global financial crises or shifts in investor confidence can lead to changes in interest rates as central banks and governments respond to the evolving situation.
  
  

Therefore, if you are an investor, you have to keep track not only of how your investments are doing but also of the general market dynamics, politics, and trends.