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Types of Investment Risk

Zoe Team

Mar 15, 2018

4 min read

A financial advisor reviewing a plan with two clients at a table

Key Takeaways

Portfolio risk stems from diverse sources including interest rates, market volatility, and inflation.
Liquidity risk can impact your ability to sell assets quickly without a significant price loss.
Understanding behavior risk is crucial to avoid emotional decision-making during market swings.

Frequently Asked Questions

What is market risk?

Market risk, or systematic risk, is the potential for an entire asset class to decline in value due to economic factors beyond your individual control.

How does inflation impact my portfolio?

Inflation risk reduces your purchasing power over time, meaning your investments must earn a return higher than the inflation rate to grow in value.

Can behavior risk really affect returns?

Yes, behavior risk refers to emotional decisions—like panic-selling during a crash—that often lead to poor long-term financial outcomes for investors.

Types of Investment Risk That Could Affect Your Portafolio

These types of risks include interest rate risk, market risk, liquidity risk, inflation risk, and behavioral risk.

As an investor, you will encounter many different kinds of risk that may affect your investments. These risks include interest rate risk, market risk, liquidity risk, and inflation risk, amongst others.

These kinds of systematic risks (un-diversifiable risks) can significantly affect your portfolio’s value in ways that may be unrelated to how the stocks or bonds in which you have invested are performing.

In addition to systematic risks, there are behavioral risks that are driven by your own biases. In other words, an important risk as an investor … is you. Let’s tackle each of these one at a time.

Interest Rate Risk

Interest rate risk refers to the manner in which changes in the base cost of borrowing money affects the expected return from different kinds of securities.

The Federal Reserve sets the short-term interest rate level at which borrowing occurs, while longer-term interest rates will move on their own based on economic conditions.

When interest rates rise, the price of bonds decreases. In contrast, when interest rates decrease, the price of bonds increases. However, the relationship between interest rates and stocks is not as clear-cut as we discussed in this blog.

Interest rates can significantly impact an investment portfolio. An investor can hedge against interest rate risk by having a portion of their portfolio in cash, or short-term bonds, which adjust to different interest rates environments.

Market Risk

Trends in a specific asset market can create a tide that pushes the price of securities up or down, despite the individual security fundamentals. This is known as market risk.

An investor can account for market risk by diversifying into different sectors that either move in opposite direction to their current assets or that have no direct relationship whatsoever.

For example, an investor wishing to hedge against market risk in stocks may decide to own bonds and real estate.

Liquidity Risk

Liquidity risk relates to the ease with which you can buy and sell securities.

While many large-cap stocks are extremely liquid i.e. easily converted to cash, as there are many buyers and sellers on a daily basis, securities in smaller companies sometimes have a significant difference between the bid and the ask prices (the spread). This means that if you suddenly decide to sell your securities, it may not be as quick and easy.

For certain types of assets, liquidity risk is more common and an important concern. For example, bonds and derivatives often have significant liquidity risk. Due to their less-frequent trading, their bid-ask spread at any one time might be quite significant, meaning that selling a bond is often not as easy as selling a stock.

If you are interested in securities that face significant liquidity risk, you may need to modify your investment strategy to account for this. One hedging strategy is to enter or exit positions in securities over a longer time frame rather than using immediate market orders.

Inflation Risk

An increase in inflation can easily make investment returns less beneficial than they might otherwise seem. Bonds and cash are particularly susceptible to inflation risk, while stocks generally rise along with inflation.

Similarly, deflation can push stock prices down significantly as earnings and cash decrease in value. Bonds benefit significantly from deflation, as the interest rate is suddenly more valuable.

Behavioral Risk

You can understand all of the risks discussed in this piece yet still be exposed to the biggest risk of all. Yourself. We have certain behavioral aspects coded into our DNA that are hard to overcome. We have anchoring, confirmation bias, insight bias, disposition effect biases. among many others. All of them can significantly hurt your chances of having a successful investment strategy as you over- or under-react to changes in the market.

How To Protect Yourself Against Risk

Each of these risks affects different asset classes in different ways. By ensuring that you have a variety of asset classes i.e. diversify your portfolio, you will ensure that you don’t overexpose yourself to one particular type of risk.

The key to protecting yourself from unwanted risk is to have a well thought out plan that you execute in a systematic fashion or working with a financial advisor.

When assessing your portfolio risk, you will need to assess your risk capacity, your risk tolerance, and your behavioral biases.

Types of Investment Risk That Could Affect Your Portafolio

These types of risks include interest rate risk, market risk, liquidity risk, inflation risk, and behavioral risk.

Interest Rate Risk

Interest rate risk refers to the manner in which changes in the base cost of borrowing money affects the expected return from different kinds of securities.

The Federal Reserve sets the short-term interest rate level at which borrowing occurs, while longer-term interest rates will move on their own based on economic conditions.

Market Risk

Trends in a specific asset market can create a tide that pushes the price of securities up or down, despite the individual security fundamentals. This is known as market risk.

An investor can account for market risk by diversifying into different sectors that either move in opposite direction to their current assets or that have no direct relationship whatsoever.

For example, an investor wishing to hedge against market risk in stocks may decide to own bonds and real estate.

Liquidity Risk

Liquidity risk relates to the ease with which you can buy and sell securities.

Inflation Risk

Similarly, deflation can push stock prices down significantly as earnings and cash decrease in value. Bonds benefit significantly from deflation, as the interest rate is suddenly more valuable.

Behavioral Risk

How To Protect Yourself Against Risk

The key to protecting yourself from unwanted risk is to have a well thought out plan that you execute in a systematic fashion or working with a financial advisor.

When assessing your portfolio risk, you will need to assess your risk capacity, your risk tolerance, and your behavioral biases.

Disclosures: Zoe Financial, Inc. ("Zoe Financial") is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Zoe Financial provides investment advisory services and access to independent registered investment advisers through its platform. The information provided by Zoe Financial is for educational and informational purposes only and should not be construed as personalized investment advice or as an offer to buy or sell any security. All investments involve risk, including possible loss of principal. Past performance is not indicative of future results. Clients should consult with their own financial, tax, or legal professionals before making any investment decisions. The material presented by Zoe Financial is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy, or investment product. Material presented has been gathered from sources believed to be reliable, however Adviser cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Past performance is no guarantee of future results. Zoe Financial does not provide legal or tax advice, and nothing contained in these materials should be taken as legal or tax advice. SEC Registration does not constitute an endorsement of Zoe Financial by the SEC nor does it indicate that Zoe Financial has attained a particular level of skill or ability. The sole purpose of this material is to inform, and it in no way is intended to be an offer or solicitation to purchase or sell any security, other investment or service, or to attract any funds or deposits. Investments mentioned may not be appropriate for all clients. Before making any investment, each investor should carefully consider the risks associated with the investment, as discussed in the applicable offering memorandum, and make a determination based upon their own particular circumstances, that the investment is consistent with their investment objectives and risk tolerance. Lower expenses do not guarantee better investment performance. Certain information contained herein may constitute forward-looking statements. Due to various risks and uncertainties, actual events, results or the performance of a fund may differ materially from those reflected or contemplated in such forward-looking statements.

Disclosure: This page is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accounting, tax, legal or financial advisors. The observations of industry trends should not be read as recommendations for stocks or sectors.

Investment advisory services are provided by Zoe Financial, Inc. (Zoe Financial), an investment adviser registered with the U.S. Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training. Learn more about Zoe Financial on the SEC’s Investment Adviser Public Disclosure website. Brokerage services are provided by Zoe Securities LLC and Apex Clearing Corporation, members of the Financial Industry Regulatory Authority Inc. (FINRA) and Securities Investor Protection Corporation (SIPC). Learn more about Zoe Securities and Apex on FINRA’s BrokerCheck website.

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