Risk refers to the potential for financial loss or uncertainty regarding the return on investment.
It is the possibility that the actual return on an investment will be different from its expected return.
This potential for loss is why investment or trading opportunities are often assessed based on risk versus reward.
What is risk?
Risk, in its simplest form, denotes the potential to lose money or not achieve the expected returns from an investment or trade.
Risk is an inherent part of trading, but traders can manage it using various strategies and tools.
These can include diversifying their bets, using stop-loss orders, and only trading money they can afford to lose (also known as “risk capital”).
Proper risk management can help to mitigate potential losses and make trading more predictable and profitable in the long term.
What are the different types of risk?
There are several types of risk that traders face:
1. Market Risk
Market risk, also known as systematic risk, is the risk that the entire market will decline, dragging down the value of virtually all investments. It’s largely unavoidable as it stems from broader economic, political, or societal factors.
For instance, news of political instability, global pandemics, or significant policy changes can all result in a widespread market downturn.
Consider the global financial crisis in 2008. Triggered by a collapse in the US housing market, it led to a pervasive fall in stock markets worldwide, with investors seeing substantial reductions in their portfolio values.
2. Liquidity Risk
Liquidity risk involves the potential inability to buy or sell an investment quickly enough to prevent or minimize a loss.
It’s particularly applicable to thinly traded or niche markets where finding a buyer or seller could prove challenging.
The lack of liquidity can lead to price manipulation or cause you to liquidate your position at an unfavorable price.
An example would be if you invested in a small-cap stock that doesn’t trade in large volumes. If adverse news about the company breaks and you decide to sell your shares, you may struggle to find buyers, forcing you to sell at a much lower price than intended.
3. Credit Risk
Credit risk, or default risk, comes into play when a bond issuer or other debtor fails to meet their payment obligations.
If you’re invested in corporate or government bonds, there’s a risk that the entity could default on its interest payments or even the return of the principal amount.
For example, if you hold bonds from a company that declares bankruptcy, the company might default on its scheduled interest payments or be unable to return the principal amount, resulting in losses for you.
3. Operational Risk
Operational risk includes risks arising from various operational failures like trading glitches, human errors, or fraudulent activities. It’s especially relevant in high-frequency trading where milliseconds can impact trading outcomes.
A famous example is the “Knight Capital incident” in 2012, where a software glitch in the firm’s high-frequency trading algorithms led to a loss of over $440 million in just 45 minutes, eventually resulting in the firm’s collapse.
4. Inflation Risk
Inflation risk is the risk that the rate of return on investment won’t keep up with the rate of inflation. In other words, the purchasing power of the returns from your investment could decline over time due to inflation.
For example, if you invest in a bond that yields a 2% annual return but inflation is running at 3%, the real value – or purchasing power – of your investment is effectively diminishing.
5. Currency Risk
In the world of forex trading, currency risk is a significant factor. It’s the risk that changes in currency exchange rates will negatively affect the value of one’s investment. It’s not just limited to forex traders but also impacts investors who hold international investments.
For example, if an American investor owns stocks in Europe, and the value of the euro falls relative to the US. dollar, when the investor sells the stocks and converts the euros back into dollars, they will receive less than anticipated, even if the stock price hadn’t moved.