Risk is the likelihood or probability that an investor’s actual return will be different from the anticipated return. Risk can also refer to the possibility of losing some or all of the original amount invested. Risk is typically measured by calculating the historical or average returns of a specific investment. When there is a high standard deviation from an investment’s historical or average returns, that indicates a correspondingly higher risk level.
Risk and Investments
All investments have an inherent degree of risk, although some investments may be riskier than others. In finance, risk and return tend to have an inverse relationship (also called an inverse correlation). Investments that are viewed as being riskier, such as stocks, typically pay higher rates of return to their investors. Investments that are lower risk, such as certain types of bonds, tend to offer lower rates of return compared to their more volatile counterparts. Certificates of deposit and money market accounts—not to be confused with money market funds—are among the lowest risk investments available. Treasury bills, which are backed by the full faith and credit of the United States government, would also fall into this category.
Risk tolerance refers to the amount of risk an investor is willing to accept in his or her portfolio. Investors who prefer an aggressive approach will generally choose riskier investments compared to investors who are more moderate or conservative in their investment choices.
Risk is a broad term that includes various categories of risk, including currency risk, inflation risk, liquidity risk, opportunity risk, interest rate risk and call risk, all of which must be considered when making investment decisions.
Risk ratings are used to assign a risk value to specific investments. The Morningstar Rating, for example, is used to rank the risk levels of publicly traded mutual funds and exchange-traded funds. The ratings scale ranges from one to five stars, with a five-star rating representing the best a fund can achieve.
Morningstar also has a rating system for individual stocks, which calculates risk by comparing a stock’s current market price with Morningstar’s estimate of its fair value. Higher rated stocks have lower risk, which could mean that their rate of return is lower than some lower-rated stocks that are more volatile and could cause you to either earn more or lose more.
Investment risk cannot be eliminated entirely, but investors can manage risk in their portfolios. Choosing investments that represent different asset classes, such as stocks, bonds, real estate or cash, increases the likelihood that some of your investments will provide consistent returns even if others stagnate or decline in value.
Investors can further manage risk by diversifying within individual asset classes and spreading funds out over multiple investments. Certain investments, such as real estate, may provide a natural hedge against risk over time.