Learning Objectives

After completing this chapter, you will be able to:

• Understand what investment risk means.
• Learn why every investment carries some level of risk.
• Identify the major types of investment risk.
• Understand the relationship between risk and return.
• Learn how investors manage investment risk.
• Make more informed investment decisions by recognising potential risks.

Introduction

Every investment involves some level of risk. While investing offers the potential to grow your wealth, there is also the possibility that the value of your investment may decrease. Understanding investment risk helps investors make informed decisions, avoid unrealistic expectations, and build portfolios that match their financial goals and comfort with risk.

What is Investment Risk?

Investment risk is the possibility that an investment may not perform as expected or may lose value.

Risk does not always mean losing money permanently. It also includes the uncertainty about future investment returns.

The higher the uncertainty, the higher the investment risk is generally considered to be.

Why is Risk Important?

Understanding risk helps investors:

• Make informed investment decisions.
• Set realistic return expectations.
• Choose investments that suit their financial goals.
• Avoid unnecessary losses.
• Build a balanced investment portfolio.

Ignoring risk can lead to poor investment decisions.

Risk and Return

One of the most important investing principles is the relationship between risk and return.

Generally:

• Higher potential returns usually involve higher risk.
• Lower-risk investments often provide lower expected returns.
• There is no guarantee that higher-risk investments will produce higher returns.

Investors should consider both the potential rewards and the risks before investing.

Common Types of Investment Risk

Investors face several different types of risk.

Market Risk

Market Risk is the possibility that the overall market declines due to economic or political events.

Examples include:

• Economic recessions.
• Interest rate changes.
• Global conflicts.
• Inflation.
• Market uncertainty.

Even strong companies can experience falling share prices during broad market downturns.

Company Risk

Company Risk relates to factors that affect an individual business.

Examples include:

• Poor financial performance.
• Weak management decisions.
• Increased competition.
• Product failures.
• Legal or regulatory issues.

This type of risk affects one company rather than the entire market.

Industry Risk

Industry Risk affects companies operating within the same sector.

Examples include:

• Falling commodity prices affecting mining companies.
• Changes in government regulations.
• New technology disrupting existing industries.
• Reduced consumer demand.

An entire industry may be affected even if individual companies are well managed.

Liquidity Risk

Liquidity Risk is the risk that investors may not be able to buy or sell an investment quickly without affecting its price.

Shares of smaller companies often have lower trading volumes, making them less liquid than larger companies.

Inflation Risk

Inflation Risk occurs when the purchasing power of your investment returns decreases because prices of goods and services increase over time.

If an investment earns less than the inflation rate, your real return may decline.

Currency Risk

Currency Risk mainly affects investments in overseas companies.

Changes in exchange rates can increase or reduce investment returns when converted back into Australian dollars.

How Investors Manage Investment Risk

Although risk cannot be eliminated completely, investors can manage it in several ways.

Common strategies include:

• Diversifying investments.
• Investing for the long term.
• Researching companies thoroughly.
• Investing across different industries.
• Regularly reviewing investment portfolios.
• Avoiding emotional investment decisions.

Good risk management focuses on reducing unnecessary risks rather than avoiding investing altogether.

Diversification

Diversification means spreading investments across different assets instead of investing all your money in one company or sector.

A diversified portfolio may include:

• Australian shares.
• International shares.
• ETFs.
• REITs.
• Fixed income investments.
• Cash.

Diversification helps reduce the impact if one investment performs poorly.

Risk Tolerance

Every investor has a different level of comfort with risk.

Your risk tolerance may depend on:

• Age.
• Financial goals.
• Investment experience.
• Income.
• Investment time horizon.
• Personal preferences.

Understanding your own risk tolerance can help you choose investments that suit your circumstances.

Reading a Real ASX Example

Let's look at a simplified example using BHP Group (BHP).

When investing in BHP, investors may consider risks such as:

• Changes in iron ore prices.
• Global economic conditions.
• Government regulations.
• Operational disruptions.
• Environmental factors.

Even large, well-established companies face investment risks that investors should understand before investing.

Why Understanding Risk Matters

Understanding investment risk helps investors answer questions such as:

• What could cause this investment to lose value?
• Does this investment match my financial goals?
• Am I comfortable with the level of risk?
• Have I diversified my investments?
• Have I researched the company before investing?

Managing risk is one of the most important skills for long-term investing success.

Key Takeaways

• Every investment carries some level of risk.
• Risk refers to the uncertainty of future investment returns.
• Higher potential returns generally involve higher levels of risk.
• Common risks include market, company, industry, liquidity, inflation, and currency risk.
• Diversification is one of the most effective ways to reduce investment risk.
• Investors should understand their own risk tolerance before making investment decisions.