Common Investing Risks and How to Manage Them

When you’re working to build your wealth, it can be natural to want safe investments with high returns.

But “safe” and “high return” rarely come as a package deal. Low-risk investments generally produce lower returns than high-risk investments. And while high-risk, speculative investments can produce greater returns, taking on more risk also means there’s a greater chance you could lose some or even all of your money.

Successful investing is largely about risk management. The goal is to take an appropriate level of risk that balances your personal situation with the potential reward you’re trying to achieve.

What is investment risk?

When most people talk about investment risk, they’re referring to the possibility that an investment will lose money. While that’s part of it, it’s not the full picture. That’s because there are multiple types of investment risk—and not all of them are related to the loss of principal. After all, even very safe investments can be risky if they don’t keep pace with inflation, which will eat into their purchasing power over time. And that’s just one example.

According to the Financial Industry Regulatory Authority(FINRA), risk is defined as “any uncertainty with respect to your investments that has the potential to negatively affect your financial welfare.”

Risk and reward

In investing, risk and reward are heavily linked. This link is known as the risk-reward relationship.

Here’s how it works: High-risk investments must offer the potential for high reward, or no investors would choose to hold them. Low-risk investments typically offer less potential for reward.

For example, with a high-quality bond, you have a fair amount of certainty about the price you’ll pay for it and how much interest you can expect to be paid back on your money. Stocks are less certain on any given day and have no promised return of principal but, historically, they tend to produce higher average returns over the long term. The more risk you take with any investment, the more potential reward you should expect.

But it's important to understand that just because an investment has the potential for high return this does not mean that those returns are guaranteed. No investment can guarantee any amount of return.

Common types of investment risk

While most people understand the difference in the risk they’re taking when they purchase a stock or a bond, there are actually a number of different types of investment risks. This list is by no means exhaustive, but it includes some of the most common types of investment risks.

1. Market risk

This may be the most common risk for investors. Market risk is simply the risk that the price of stocks, bonds, commodities and other common investments will move day to day—or even minute to minute.

This volatility can be a problem if you’re concerned about short-term price movements. In other words, this is a greater risk if you need to access your investments in the near term. But if you don’t need to access your money right away, you may be willing to accept this risk in order to see a potentially greater return over time.

2. Interest rate risk

Interest rate risk is typically paired with market risk. That’s because a change in interest rates can affect the value of bonds: As interest rates rise, yields on new bonds will typically increase, driving down the value of existing bonds with lower yields.

Interest rate risk is a factor when owning bonds as rising or falling rates affect bond prices. It can also impact the price of stocks. However, like market risk, this is typically less of an issue when you plan to hold stocks and bonds for long-term goals, as a longer time horizon tends to smooth out the shorter-term fluctuations.

3. Credit risk

Credit risk refers to the possibility that a borrower might not be able to meet its lending obligations and repay debt. It is also called “default risk.”

If you hold bonds—particularly corporate bonds—you should pay attention to credit risk, because when you purchase a corporate bond, you’re essentially lending a company money to get interest payments in return. As an investor, you should look at factors like cash flow and credit ratings to get a sense of the credit risk a company poses.

The greater the risk that a borrower may default, the higher the interest (known as “coupons” on bonds) you should expect to get in return. However, you’re also weighing this with the higher possibility that the company may default on its debt.

4. Inflation risk

This one is interesting in that it is risk typically associated with “safe” assets. Inflation risk refers to the possibility that your returns will not keep up with the rate of inflation, which could translate into a loss of purchasing power over time.

Inflation can be a major concern for more conservative investments like cash, cash equivalents and even bonds, which tend to provide lower total returns over time than assets like stocks. Inflation risk is why it can be a good idea to take more risk with money that you don't intend to access in the short term.

5. Liquidity risk

Liquidity risk is a measure of how readily you can convert your assets into cash at a fair price. Generally speaking, cash, cash equivalents, stocks and bonds are all considered to be relatively liquid assets because there is a well-established market for buying and selling them. Hard assets like real estate and collectibles are often considered to be less liquid—and have a higher liquidity risk—because it’s not always easy to quickly convert their value to cash.

It’s typically a good idea to make sure you have enough liquid assets to cover your immediate needs. But if you won’t need your money right away, taking on some liquidity risk can help you earn a premium over more-liquid assets and help to grow the value of your money over time.

6. Currency risk

If you hold foreign investments, the performance of those investments will depend in part on the exchange rate between currencies. If an exchange rate were to move rapidly in one direction or another, it could have a major impact on investments you have in that country. This is currency risk, also known as exchange-rate risk.

While currency risk can negatively impact investments, the opposite can also be true. This is where a well-diversified portfolio, incorporating both domestic and international investments denominated in foreign currencies, can come into play; being diversified helps you manage shifts in any one currency.

7. Political risk

Political risk, also referred to as regulatory risk, refers to the likelihood that an investment’s performance might be influenced by political developments. This can include political instability, unexpected regime changes, unexpected election results, military activities, the introduction of new laws and regulations and more.

While political risk can cause movements in both the broader market and in pockets of the market, this risk may sometimes feel more magnified and relevant than it actually is.

8. Sequence of returns risk

The order in which your portfolio realizes its returns over time can impact its longevity, especially when paired with withdrawals. This is sequence of returns risk.

This type of risk is why many financial advisors advise against starting withdrawals during a recession or a market downturn, if at all possible. By waiting until your portfolio has had the chance to recover before you begin making withdrawals, you increase the likelihood that your portfolio will be able to withstand future withdrawals as well as down years.

9. Systematic vs. unsystematic risk

The investing risks mentioned generally exist in one of two categories: systematic risk and unsystematic risk.

Systematic risk is risk that is tied to the performance of the overall market such as a broad selloff tied to a recession. Unsystematic risk is tied to individual companies or sectors—for example, a company that overpromised about a major product launch and experiences a significant and abrupt drop in value.

How can I mitigate risk in my investments?

It’s difficult to completely avoid risk, but there are some strategies you can use to manage risk in your portfolio.

Diversify your portfolio

To manage risk, you’ll want to spread your risk exposure out among a variety of investments vs. putting all of your eggs in one basket. This way, if one of your investments is doing poorly, you still have others that may not be.

There are many ways to diversify your portfolio: You can spread your investments among broad asset classes like stocks, bonds and commodities and diversify further into different sectors and industries, which come with different degrees of risk. Diversification is not something you do just once; regularly checking in on and rebalancing your portfolio helps you stay prudently diversified at your preferred risk level.

Adjust your risk tolerance over time

You’ll also want to adjust your risk level depending on where you’re at in life and when you’ll need your money.

Investing in stocks can be risky, but it also can allow you to earn significant returns. If you're young and you won’t need to tap into your investments for a long time, a riskier investment strategy may be a better fit because you can wait out short-term volatility until the money is needed.

If you’re nearing retirement (or when you would otherwise need your money), you’ll likely want to reduce the amount of risk you’re taking with your investments. You can do this by making adjustments to your portfolio.

Consult with an advisor

Ultimately, the key to managing investment risk is to build a well-diversified financial plan that is tailored to you. Your Northwestern Mutual financial advisor can help you understand your risk tolerance and show you how a range of financial options—including a mix of traditional and nontraditional investments—can help grow your wealth over time.

This article is for informational and educational purposes only and should not be interpreted as financial or investment advice. All investments carry some level of risk including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against loss.