Any investment represents the decision to accept risk and those risks can come in many different forms. Therefore it is important to understand those risks and ensure that you can expect to be compensated for bearing those risks.
It is important to remember
- Investment values can increase (go up) and decrease (go down)
- It is possible to recieve less back than you originally invested
- Past performance is not an indication of future outcomes
The Many Forms Of Risk
It is common to think about investment Return vs. investment Risk. However, risk can come in many different forms. So, while it is important to consider general uncertainty and risk it is equally if not more important to consider the varieties and forms of risk.
- General Uncertainty: The top level of risk is general uncertainty about the future. This is measured with the metric standard deviation by convention. In short, this is the average distance of the uncertainty (on both sides +/-) from your expectation.
- For example, if you expected an 8% return but the standard deviation was 10% than the average range of your uncertainty would be between -2% and 18% and this of course, could also be 2x or more that range.
- Factor Risk: While sometimes associated with quantitative metrics, a factor can be any specific type of risk. They can be quantitative, fundamental, or otherwise.
A non-comprehensive but important list of potential factors are:
- Liquidity: This is the risk you can not get your invested cash out of your investment.
- Economic: Is a set of risks that link your investment to the underlying economy.
- Inflation: Is an important risk because when it rises it reduces the purchasing power of your money. This means that not growing your money above inflation makes you poorer.
- Market: Is a set of risks that link your investment to market fundamentals and specific market risks.
- Valuation: This is the risk that the original purchase price of your investment was not appropriate to the underlying value.
- Services: Investment service, vehicles, and management comes with its' own set of risks. While this is a long list of potential risk they tend to be related to the investment vehicle, strategy and/or the people running those services.