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Investments- Stocks/Bonds/Mutual funds. Exploring Risks and Factors.

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Investments- Stocks/Bonds/Mutual funds. Exploring Risks and Factors.

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Have you ever wondered the risks of buying or sharing bonds, stocks or mutual funds? Just like everything else pros always comes cons. Throughout this pallet you will learn about the risks and factors of stocks, bonds and mutual funds as well as the do's and don'ts of it all.

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The positives of mutual funds are advance portfolio management, Dividend Reinvestment, and risk reduction. Although there are many more advantages these are some of the best ones. When your buying a mutual fund your paying a management fee as part of your ratio this is used to hire a professional portfolio manager who buy and sells stocks, bonds, etc. Not sure what dividend reinvestment means well they can be used to purchase additional shares in the mutual fund, therefore helping your investment grow. Risk reduction is a use of diversification most funds will be anywhere from 50 to 200 different securities—depending on the focus. I picked this website because it listed both disadvantages and advantages of mutual funds as well as the describe of each risk/factor.

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Mutual funds are one of the most popular investment vehicles for many investors. They come with many advantages, such as advanced portfolio management, risk reduction, and dividend reinvestment; however, there are many disadvantages to consider as well, such as high expense ratios and sales charges, tax inefficiencies, and possible management abuses. Before investing in one, read on to learn more details about the advantages and disadvantages of investing in mutual funds.

Key Takeaways

Mutual Funds: An Overview

Mutual funds pool together investments from shareholders to invest in securities, such as stocks, bonds, and other assets. There are a variety of funds covering different industries and different asset classes and they are managed by professional portfolio managers who seek to achieve capital gains for the fund's investors. Investors are charged various fees for the services that mutual funds provide.

When an investor invests in a mutual fund, they are seeking exposure to a variety of assets, do not have voting rights, and may be subject to certain rules, requirements, and certainly fees. Most mutual funds are managed and offered by large investment management companies, such as Vanguard and Fidelity.

Some of the advantages of mutual funds include advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing, while disadvantages include high expense ratios and sales charges, management abuses, tax inefficiency, and poor trade execution.

Advantages of Mutual Funds

There are many reasons why investors choose to invest in mutual funds with such frequency. Let's break down the details of a few.

Advanced Portfolio Management

When you buy a mutual fund, you pay a management fee as part of your expense ratio, which is used to hire a professional portfolio manager who buys and sells stocks, bonds, etc. This is a relatively small price to pay for getting professional help in the management of an investment portfolio.

Dividend Reinvestment

As dividends and other interest income sources are declared for the fund, they can be used to purchase additional shares in the mutual fund, therefore helping your investment grow.

Risk Reduction (Safety)

Reduced portfolio risk is achieved through the use of diversification, as most mutual funds will invest in anywhere from 50 to 200 different securities-depending on the focus. Numerous stock index mutual funds own 1,000 or more individual stock positions.

Convenience and Fair Pricing

Mutual funds are easy to buy and easy to understand. They typically have low minimum investments and they are traded only once per day at the closing net asset value (NAV). This eliminates price fluctuation throughout the day and various arbitrage opportunities that day traders practice.

Disadvantages of Mutual Funds

However, there are also disadvantages to being an investor in mutual funds. Here's a more detailed look at some of those concerns.

High Expense Ratios and Sales Charges

If you're not paying attention to mutual fund expense ratios and sales charges, they can get out of hand. Be very cautious when investing in funds with expense ratios higher than 1.50%, as they are considered to be on the higher cost end. Be wary of 12b-1 advertising fees and sales charges in general. There are several good fund companies out there that have no sales charges. Fees reduce overall investment returns.

Management Abuses

Churning, turnover, and window dressing may happen if your manager is abusing their authority. This includes unnecessary trading, excessive replacement, and selling the losers prior to quarter-end to fix the books.

Tax Inefficiency

Like it or not, investors do not have a choice when it comes to capital gains payouts in mutual funds. Due to the turnover, redemptions, gains, and losses in security holdings throughout the year, investors typically receive distributions from the fund that are an uncontrollable tax event.

Poor Trade Execution

If you place your mutual fund trade anytime before the cut-off time for same-day NAV, you'll receive the same closing price NAV for your buy or sell on the mutual fund. For investors looking for faster execution times, maybe because of short investment horizons, day trading, or timing the market, mutual funds provide a weak execution strategy.

What Are the Risks of Mutual Funds?

No investment is risk-free and while mutual funds are generally low-risk because they invest in low-risk securities, they are not completely risk-free. The securities held in a mutual fund may lose value either due to market conditions or to the performance of a specific security, such as the stock of a company if the company performs poorly. Other risks could be difficult to predict, such as risks from the management team or a change in policy regarding dividends and fees.

What Are Certain Advantages of Mutual Funds?

Mutual funds have plenty of advantages, including diversification, professional management, low costs, and convenience.

Are Mutual Funds Better Than Stocks?

Determining what is a better investment depends solely on the specific investor, their investment objectives, and their risk tolerance. Mutual funds allow for ease of access to a wide array of investments/companies, which increases diversification. They also carry lower risk because of that fact as opposed to investing in just a few stocks.

The Bottom Line

Mutual funds are a great way for investors to gain exposure to a wide variety of assets without having to specifically purchase investment securities one by one. They also allow an investor to leave the investment decisions up to a professional. While they can be a great and safe investment, they do not come without their flaws and issues.

Before investing, make sure to take your time researching the right mutual fund for you, being aware of the types of investments, risks, and costs associated with each particular fund you are considering and how they fit into your investment objectives.

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Mutual Funds: Advantages and Disadvantages

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Among the most popular investment vehicles, there are advantages and disadvantages to consider before investing in mutual funds.

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Stock the risk and factors, One of the most considering factors of stocks are growth vs value Investors often consider whether a stock exhibits growth potential or is undervalued (value-oriented). Another risk about stocks are the expected growth in the earnings base. I picked this website because of it's usefulness and how helpful the information was. What I found useful was the explanation after each risk factor.

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Stock prices are determined in the marketplace, where seller supply meets buyer demand. But have you ever wondered about what drives the stock market-that is, what factors affect a stock's price? Unfortunately, there is no clean equation that tells us exactly how the price of a stock will behave. That said, we do know a few things about the forces that move a stock up or down. These forces fall into three categories: fundamental factors, technical factors, and market sentiment.

Fundamental Factors

In an efficient market, stock prices would be determined primarily by fundamentals, which, at the basic level, refer to a combination of two things:

1. An earnings base, such as earnings per share (EPS)

2. A valuation multiple, such as a P/E ratio

An owner of common stock has a claim on earnings, and earnings per share (EPS) is the owner's return on their investment. When you buy a stock, you are purchasing a proportional share of an entire future stream of earnings. That's the reason for the valuation multiple: It is the price you are willing to pay for the future stream of earnings.

Part of these earnings may be distributed as dividends, while the remainder will be retained by the company (on your behalf) for reinvestment. We can think of the future earnings stream as a function of both the current level of earnings and the expected growth in this earnings base.

As shown in the diagram, the valuation multiple (P/E), or the stock price as some multiple of EPS, is a way of representing the discounted present value of the anticipated future earnings stream.

The Earnings Base

Although we are using EPS, an accounting measure, to illustrate the concept of earnings base, there are other measures of earnings power. Many argue that cash-flow-based measures are superior. For example, free cash flow per share is used as an alternative measure of earnings power.

The way earnings power is measured may also depend on the type of company being analyzed. Many industries have their own tailored metrics. Real estate investment trusts (REITs), for example, use a special measure of earnings power called funds from operations (FFO). Relatively mature companies are often measured by dividends per share, which represents what the shareholder actually receives.

The Valuation Multiple

The valuation multiple expresses expectations about the future. As we already explained, it is fundamentally based on the discounted present value of the future earnings stream. Therefore, the two key factors here are:

1. The expected growth in the earnings base

2. The discount rate, which is used to calculate the present value of the future stream of earnings

A higher growth rate will earn the stock a higher multiple, but a higher discount rate will earn a lower multiple.

What determines the discount rate? First, it is a function of perceived risk. A riskier stock earns a higher discount rate, which, in turn, earns a lower multiple. Second, it is a function of inflation (or interest rates, arguably). Higher inflation earns a higher discount rate, which earns a lower multiple (meaning the future earnings are going to be worth less in inflationary environments).

In summary, the key fundamental factors are as follows:

The level of the earnings base (represented by measures such as EPS, cash flow per share, dividends per share)

The expected growth in the earnings base

The discount rate, which is itself a function of inflation

The perceived risk of the stock

Technical Factors

Things would be easier if only fundamental factors set stock prices. Technical factors are the mix of external conditions that alter the supply of and demand for a company's stock. Some of these indirectly affect fundamentals. For example, economic growth indirectly contributes to earnings growth.

Technical factors include the following.

We mentioned it earlier as an input into the valuation multiple, but inflation is a huge driver from a technical perspective as well. Historically, low inflation has had a strong inverse correlation with valuations (low inflation drives high multiples and high inflation drives low multiples). Deflation, on the other hand, is generally bad for stocks because it signifies a loss in pricing power for companies.

Economic Strength of Market and Peers

Company stocks tend to track with the market and with their sector or industry peers. Some prominent investment firms argue that the combination of overall market and sector movements-as opposed to a company's individual performance-determines a majority of a stock's movement. (Research has suggested that economic/market factors account for 90% of it.) For example, a suddenly negative outlook for one retail stock often hurts other retail stocks as "guilt by association" drags down demand for the whole sector.

Substitutes

Companies compete for investment dollars with other asset classes on a global stage. These include corporate bonds, government bonds, commodities, real estate, and foreign equities. The relationship between demand for U.S. equities and their substitutes is hard to figure, but it plays an important role.

Incidental Transactions

Incidental transactions are purchases or sales of a stock that are motivated by something other than belief in the intrinsic value of the stock. These transactions include executive insider transactions, which are often pre-scheduled or driven by portfolio objectives. Another example is an institution buying or shorting a stock to hedge some other investment. Although these transactions may not represent official "votes cast" for or against the stock, they do impact supply and demand and, therefore, can move the price.

Demographics

Some important research has been done about the demographics of investors. Much of it concerns these two dynamics:

1. Middle-aged investors, peak earners who tend to invest in the stock market

2. Older investors, who tend to pull out of the market in order to meet the demands of retirement

The hypothesis is that the greater the proportion of middle-aged investors among the investing population, the greater the demand for equities and the higher the valuation multiples.

Often a stock simply moves according to a short-term trend. On the one hand, a stock that is moving up can gather momentum, as "success breeds success" and popularity buoys the stock higher. On the other hand, a stock sometimes behaves the opposite way in a trend and does what is called reverting to the mean.

Unfortunately, because trends cut both ways and are more obvious in hindsight, knowing that stocks are "trendy" does not help us predict the future.

Liquidity is an important and sometimes under-appreciated factor. It refers to how much interest from investors a specific stock attracts. Walmart's stock, for example, is highly liquid and thus highly responsive to material news; the average small-cap company is less so. Trading volume is not only a proxy for liquidity, but it is also a function of corporate communications (that is, the degree to which the company is getting attention from the investor community).

Large-cap stocks have high liquidity-they are well followed and heavily transacted. Many small-cap stocks suffer from an almost permanent "liquidity discount" because they simply are not on investors' radar screens.

While it is hard to quantify the impact of news or unexpected developments inside a company, industry, or the global economy, you can't argue that it does influence investor sentiment. The political situation, negotiations between countries or companies, product breakthroughs, mergers and acquisitions, and other unforeseen events can impact stocks and the stock market. Since securities trading happens across the world and markets and economies are interconnected, news in one country can impact investors in another almost instantly.

News related to a specific company, such as the release of a company's earnings report, can also influence the price of a stock (particularly if the company is posting after a bad quarter).

In general, strong earnings generally result in the stock price moving up (and vice versa). But some companies that are not making that much money still have a rocketing stock price. This rising price reflects investor expectations that the company will be profitable in the future. However, regardless of the stock price, there are no guarantees that a company will fulfill investors' current expectations of becoming a high-earning company in the future.

Market Sentiment

Market sentiment refers to the psychology of market participants, individually and collectively. This is perhaps the most vexing category. Market sentiment is often subjective, biased, and obstinate. For example, you can make a solid judgment about a stock's future growth prospects, and the future may even confirm your projections, but in the meantime, the market may myopically dwell on a single piece of news that keeps the stock artificially high or low. And you can sometimes wait a long time in the hope that other investors will notice the fundamentals.

Market sentiment is being explored by the relatively new field of behavioral finance. It starts with the assumption that markets are apparently not efficient much of the time, and this inefficiency can be explained by psychology and other social science disciplines. The idea of applying social science to finance was fully legitimized when Daniel Kahneman, Ph.D., a psychologist, won the 2002 Nobel Memorial Prize in Economic Sciences (the first psychologist to do so). Many of the ideas in behavioral finance confirm observable suspicions: that investors tend to overemphasize data that come easily to mind; that many investors react with greater pain to losses than with pleasure to equivalent gains; and that investors tend to persist in a mistake.

Some investors claim to be able to capitalize on the theory of behavioral finance. For the majority, however, the field is new enough to serve as the "catch-all" category, where everything we cannot explain is deposited.

The Bottom Line

Different types of investors depend on different factors. Short-term investors and traders tend to incorporate and may even prioritize technical factors. Long-term investors prioritize fundamentals and recognize that technical factors play an important role. Investors who believe strongly in fundamentals can reconcile themselves to technical forces with the following popular argument: technical factors and market sentiment often overwhelm the short run, but fundamentals will set the stock price in the long-run. In the meantime, we can expect more exciting developments in the area of behavioral finance, especially since traditional financial theories cannot seem to explain everything that happens in the market.

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You can't predict exactly how stocks will behave, but knowing what forces affect prices will put you ahead of the pack.

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The risk and reward of Bonds, as shown in this image things that have risk can also have rewards. This image shows all risk factors as well as the rewarded.

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After watching this Ted Talk I have learned how investments are doing in the world and if people should keep money in there wallet or try spending it to make a little more money by investing stocks or mutual funds. This video was about investments and if they are worth it in the end. Do they put more money back into your bank account or are you losing money in the end results. Kevin talked about the economy and how it affects the investments. A piece of information I found useful was the word choice he used to make the video make sense. I picked this video because it was a reliable source.

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Impact Investing: Your money doing good in the world – and your wallet | Kevin Peterson | TEDxFargo

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1. What did you learn about your topic that surprised you the most

Sometimes Stocks, Funds or Bonds aren't worth buying. They can make you lose money instead of gain.

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2. A real life example of how this topic is relevant is when I go and buy a stock, bond or mutual fund I will know the risks and factors, as well as if they are worth buying or not.

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3. I think the most important information to pass on would be learn and research your investments, make sure you buy one that won't always crash.

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The reason on why stocks prices go up relay on a lot of things such as supply, demand and economic reports. As groceries go up in price so does the economy, which affects the stocks pricing.

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Mutual funds risks include high expense ratios as well as management abuses. If your not cautious, ratios and sales chargers can get out of hand. Pay close attention when investing into funds with a ratio higher then 1.50% as they are on the higher end of money. Turnovers, cheating and window dressing may occur if your manager is abusing their authority. What I just said above sums up the website about the disadvantages of mutual funds. I choose this website because the information was useful, there was facts throw in and the set up/ lay out was well organized. I found useful is the pieces of information they picked to put on the website.

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Mutual funds are one of the most popular investment vehicles for many investors. They come with many advantages, such as advanced portfolio management, risk reduction, and dividend reinvestment; however, there are many disadvantages to consider as well, such as high expense ratios and sales charges, tax inefficiencies, and possible management abuses. Before investing in one, read on to learn more details about the advantages and disadvantages of investing in mutual funds.

Key Takeaways

Mutual Funds: An Overview

Mutual funds pool together investments from shareholders to invest in securities, such as stocks, bonds, and other assets. There are a variety of funds covering different industries and different asset classes and they are managed by professional portfolio managers who seek to achieve capital gains for the fund's investors. Investors are charged various fees for the services that mutual funds provide.

When an investor invests in a mutual fund, they are seeking exposure to a variety of assets, do not have voting rights, and may be subject to certain rules, requirements, and certainly fees. Most mutual funds are managed and offered by large investment management companies, such as Vanguard and Fidelity.

Some of the advantages of mutual funds include advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing, while disadvantages include high expense ratios and sales charges, management abuses, tax inefficiency, and poor trade execution.

Advantages of Mutual Funds

There are many reasons why investors choose to invest in mutual funds with such frequency. Let's break down the details of a few.

Advanced Portfolio Management

When you buy a mutual fund, you pay a management fee as part of your expense ratio, which is used to hire a professional portfolio manager who buys and sells stocks, bonds, etc. This is a relatively small price to pay for getting professional help in the management of an investment portfolio.

Dividend Reinvestment

As dividends and other interest income sources are declared for the fund, they can be used to purchase additional shares in the mutual fund, therefore helping your investment grow.

Risk Reduction (Safety)

Reduced portfolio risk is achieved through the use of diversification, as most mutual funds will invest in anywhere from 50 to 200 different securities-depending on the focus. Numerous stock index mutual funds own 1,000 or more individual stock positions.

Convenience and Fair Pricing

Mutual funds are easy to buy and easy to understand. They typically have low minimum investments and they are traded only once per day at the closing net asset value (NAV). This eliminates price fluctuation throughout the day and various arbitrage opportunities that day traders practice.

Disadvantages of Mutual Funds

However, there are also disadvantages to being an investor in mutual funds. Here's a more detailed look at some of those concerns.

High Expense Ratios and Sales Charges

If you're not paying attention to mutual fund expense ratios and sales charges, they can get out of hand. Be very cautious when investing in funds with expense ratios higher than 1.50%, as they are considered to be on the higher cost end. Be wary of 12b-1 advertising fees and sales charges in general. There are several good fund companies out there that have no sales charges. Fees reduce overall investment returns.

Management Abuses

Churning, turnover, and window dressing may happen if your manager is abusing their authority. This includes unnecessary trading, excessive replacement, and selling the losers prior to quarter-end to fix the books.

Tax Inefficiency

Like it or not, investors do not have a choice when it comes to capital gains payouts in mutual funds. Due to the turnover, redemptions, gains, and losses in security holdings throughout the year, investors typically receive distributions from the fund that are an uncontrollable tax event.

Poor Trade Execution

If you place your mutual fund trade anytime before the cut-off time for same-day NAV, you'll receive the same closing price NAV for your buy or sell on the mutual fund. For investors looking for faster execution times, maybe because of short investment horizons, day trading, or timing the market, mutual funds provide a weak execution strategy.

What Are the Risks of Mutual Funds?

No investment is risk-free and while mutual funds are generally low-risk because they invest in low-risk securities, they are not completely risk-free. The securities held in a mutual fund may lose value either due to market conditions or to the performance of a specific security, such as the stock of a company if the company performs poorly. Other risks could be difficult to predict, such as risks from the management team or a change in policy regarding dividends and fees.

What Are Certain Advantages of Mutual Funds?

Mutual funds have plenty of advantages, including diversification, professional management, low costs, and convenience.

Are Mutual Funds Better Than Stocks?

Determining what is a better investment depends solely on the specific investor, their investment objectives, and their risk tolerance. Mutual funds allow for ease of access to a wide array of investments/companies, which increases diversification. They also carry lower risk because of that fact as opposed to investing in just a few stocks.

The Bottom Line

Mutual funds are a great way for investors to gain exposure to a wide variety of assets without having to specifically purchase investment securities one by one. They also allow an investor to leave the investment decisions up to a professional. While they can be a great and safe investment, they do not come without their flaws and issues.

Before investing, make sure to take your time researching the right mutual fund for you, being aware of the types of investments, risks, and costs associated with each particular fund you are considering and how they fit into your investment objectives.

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Mutual Funds: Advantages and Disadvantages

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Among the most popular investment vehicles, there are advantages and disadvantages to consider before investing in mutual funds.

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Bonds risks are Interest Rate Risk and Bond Prices as interest rates fall, bond prices go up. This can be a very bad thing which we have to pay attention and watch out for. This website teaches others the risks of bonds so they know what to look out for when investing into bonds. Someone that likes to invest I would say this website was very helpful for learning about bonds .One piece of information i found useful was the facts they used. I picked this website compared to another one because i like the style and word choice it used.

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Bonds can be a great tool to generate income and are widely considered to be a safe investment, especially compared with stocks. However, investors should be aware of the potential pitfalls of holding corporate bonds and government bonds. Below, we'll discuss the risks that could impact your hard-earned returns.

1. Interest Rate Risk and Bond Prices

The first thing a bond buyer should understand is the inverse relationship between interest rates and bond prices. As interest rates fall, bond prices rise. Conversely, when interest rates rise, bond prices tend to fall.

This happens because when interest rates are on the decline, investors try to capture or lock in the highest rates they can for as long as they can. To do this, they will scoop up existing bonds that pay a higher interest rate than the prevailing market rate. This increase in demand translates into an increase in bond prices.

On the flip side, if the prevailing interest rate is on the rise, investors would naturally jettison bonds that pay lower interest rates. This would force bond prices down.

Let's look at an example. An investor owns a bond that trades at par value and carries a 4% yield. Suppose the prevailing market interest rate rises to 5%. What will happen? Investors will want to sell the 4% bonds in favor of bonds that return 5%, which will, in turn, send the price of the 4% bonds below par. In bond terminology, duration measures the sensitivity of the price of a bond to a change in interest rates. If interest rates rise, bond prices will fall, and the duration tells you by how much given a 1% change in rates.

2. Reinvestment Risk and Callable Bonds

Another danger bond investors face is reinvestment risk, which is the risk of having to reinvest proceeds at a lower rate than what the funds were previously earning. One of the main ways this risk presents itself is when interest rates fall over time and callable bonds are exercised by the issuers.

The callable feature allows the issuer to redeem the bond prior to maturity. As a result, the bondholder receives the principal payment, which is often at a slight premium to the par value.

However, the downside to a bond call is the investor is then left with a pile of cash they might not be able to reinvest at a comparable rate. This reinvestment risk can adversely impact investment returns over time.

To compensate for this risk, investors receive a higher yield on the bond than they would on a similar bond that isn't callable. Active bond investors can attempt to mitigate reinvestment risk in their portfolios by staggering the potential call dates of differing bonds. This limits the chance that many bonds will be called at once.

3. Inflation Risk

When an investor buys a bond, they essentially commit to receiving a rate of return, either fixed or variable, for the time that the bond is held. And what happens if the cost of living and inflation increase dramatically, and at a faster rate than income investment? When this happens, investors will see their purchasing power erode, and they may actually achieve a negative rate of return when factoring in inflation.

Put another way, suppose an investor earns a 3% rate of return on a bond. If inflation grows at 4% after the bond purchase, the investor's true rate of return is -1% because of the decrease in purchasing power.

4. Credit/Default Risk

When an investor purchases a bond, they are actually purchasing a certificate of debt. Simply put, this is borrowed money the company must repay over time with interest. Many investors don't realize that corporate bonds aren't guaranteed by the full faith and credit of the U.S. government but instead depend on the issuer's ability to repay that debt.

Investors must consider the possibility of default and factor this risk into their investment decision. As one means of analyzing the possibility of default, some analysts and investors will determine a company's coverage ratio before initiating an investment. They will analyze the company's income and cash flow statements, determine its operating income and cash flow, and then weigh that against its debt service expense. The theory is the greater the coverage (or operating income and cash flow) in proportion to the debt service expenses, the safer the investment.

5. Rating Downgrades

A company's ability to operate and repay its debt issues is frequently evaluated by major rating institutions such as Standard & Poor's Ratings Services or Moody's Investors Service. Ratings range from AAA for high credit quality investments to D for bonds in default. The decisions made and judgments passed by these agencies carry a lot of weight on investors.

If an issuer's corporate credit rating is low or its ability to operate and repay is questioned, banks and lending institutions will take notice and may charge a higher interest rate for future loans. This can adversely impact the company's ability to satisfy its debts and hurt existing bondholders who might have been looking to unload their positions.

6. Liquidity Risk

While there is almost always a ready market for government bonds, corporate bonds are sometimes entirely different animals. There is a risk an investor might not be able to sell their corporate bonds quickly due to a thin market with few buyers and sellers for the bond.

Low buying interest in a particular bond issue can lead to substantial price volatility and adversely impact a bondholder's total return upon sale. Much like stocks that trade in a thin market, you may be forced to take a far lower price than expected when selling your position in the bond.

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Bonds can be a great tool to generate income, but investors need to be aware of the pitfalls and risks of holding corporate and/or government securities.

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The risky the stock is the more return there is, this video talks about standard deviation, risk: what it means to invest, how to measure and manage it. This video also talks about time horizon, this means the length of time you can part with your money before you need it again. A low risk stock will have low swings and therefor be more predictable. I found this video useful because of how short it was, some videos are long and I can get distracted with other things. I choice this video because of the quality it provided.

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What Is Risk?

Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment.

Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In finance, standard deviation is a common metric associated with risk. Standard deviation provides a measure of the volatility of asset prices in comparison to their historical averages in a given time frame.

Overall, it is possible and prudent to manage investing risks by understanding the basics of risk and how it is measured. Learning the risks that can apply to different scenarios and some of the ways to manage them holistically will help all types of investors and business managers to avoid unnecessary and costly losses.

The Basics of Risk

Everyone is exposed to some type of risk every day-whether it's from driving, walking down the street, investing, capital planning, or something else. An investor's personality, lifestyle, and age are some of the top factors to consider for individual investment management and risk purposes. Each investor has a unique risk profile that determines their willingness and ability to withstand risk. In general, as investment risks rise, investors expect higher returns to compensate for taking those risks.

A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an investor is willing to take, the greater the potential return. Risks can come in various ways and investors need to be compensated for taking on additional risk. For example, a U.S. Treasury bond is considered one of the safest investments and when compared to a corporate bond, provides a lower rate of return. A corporation is much more likely to go bankrupt than the U.S. government. Because the default risk of investing in a corporate bond is higher, investors are offered a higher rate of return.

Quantifiably, the risk is usually assessed by considering historical behaviors and outcomes. In finance, standard deviation is a common metric associated with risk. Standard deviation provides a measure of the volatility of a value in comparison to its historical average. A high standard deviation indicates a lot of value volatility and therefore a high degree of risk.

Individuals, financial advisors, and companies can all develop risk management strategies to help manage risks associated with their investments and business activities. Academically, there are several theories, metrics, and strategies that have been identified to measure, analyze, and manage risks. Some of these include standard deviation, beta, Value at Risk (VaR), and the Capital Asset Pricing Model (CAPM).

Measuring and quantifying risk often allow investors, traders, and business managers to hedge some risks away by using various strategies including diversification and derivative positions.

Riskless Securities

While it is true that no investment is fully free of all possible risks, certain securities have so little practical risk that they are considered risk-free or riskless.

Riskless securities often form a baseline for analyzing and measuring risk. These types of investments offer an expected rate of return with very little or no risk. Oftentimes, all types of investors will look to these securities for preserving emergency savings or for holding assets that need to be immediately accessible.

Examples of riskless investments and securities include certificates of deposits (CDs), government money market accounts, and U.S. Treasury bills. The 30-day U.S. Treasury bill is generally viewed as the baseline, risk-free security for financial modeling. It is backed by the full faith and credit of the U.S. government, and, given its relatively short maturity date, has minimal interest rate exposure.

Risk and Time Horizons

Time horizon and liquidity of investments is often a key factor influencing risk assessment and risk management. If an investor needs funds to be immediately accessible, they are less likely to invest in high risk investments or investments that cannot be immediately liquidated and more likely to place their money in riskless securities.

Time horizons will also be an important factor for individual investment portfolios. Younger investors with longer time horizons to retirement may be willing to invest in higher risk investments with higher potential returns. Older investors would have a different risk tolerance since they will need funds to be more readily available.

Types of Financial Risk

Every saving and investment action involves different risks and returns. In general, financial theory classifies investment risks affecting asset values into two categories: systematic risk and unsystematic risk. Broadly speaking, investors are exposed to both systematic and unsystematic risks.

Systematic risks, also known as market risks, are risks that can affect an entire economic market overall or a large percentage of the total market. Market risk is the risk of losing investments due to factors, such as political risk and macroeconomic risk, that affect the performance of the overall market. Market risk cannot be easily mitigated through portfolio diversification. Other common types of systematic risk can include interest rate risk, inflation risk, currency risk, liquidity risk, country risk, and sociopolitical risk.

Unsystematic risk, also known as specific risk or idiosyncratic risk, is a category of risk that only affects an industry or a particular company. Unsystematic risk is the risk of losing an investment due to company or industry-specific hazard. Examples include a change in management, a product recall, a regulatory change that could drive down company sales, and a new competitor in the marketplace with the potential to take away market share from a company. Investors often use diversification to manage unsystematic risk by investing in a variety of assets.

In addition to the broad systematic and unsystematic risks, there are several specific types of risk, including:

Business Risk

Business risk refers to the basic viability of a business-the question of whether a company will be able to make sufficient sales and generate sufficient revenues to cover its operational expenses and turn a profit. While financial risk is concerned with the costs of financing, business risk is concerned with all the other expenses a business must cover to remain operational and functioning. These expenses include salaries, production costs, facility rent, office, and administrative expenses. The level of a company's business risk is influenced by factors such as the cost of goods, profit margins, competition, and the overall level of demand for the products or services that it sells.

Operational risk is a type of business risk that arises from the day-to-day operation of a business and can include risks associated with system failures, human errors, fraud, or other internal processes that might negatively impact a business's financial performance. Operational risks can be managed through effective internal controls, processes, and systems.

Businesses and investments can also be exposed to legal risks stemming from changes in laws, regulations, or legal disputes. Legal and regulatory risks can be managed through compliance programs, monitoring changes in regulations, and seeking legal advice as needed.

Credit or Default Risk

Credit risk is the risk that a borrower will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is particularly concerning to investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal government, have the least amount of default risk and, as such, the lowest returns. Corporate bonds, on the other hand, tend to have the highest amount of default risk, but also higher interest rates.

Bonds with a lower chance of default are considered investment grade, while bonds with higher chances are considered high yield or junk bonds. Investors can use bond rating agencies -such as Standard and Poor's, Fitch and Moody's-to determine which bonds are investment-grade and which are junk.

Country Risk

Country risk refers to the risk that a country won't be able to honor its financial commitments. When a country defaults on its obligations, it can harm the performance of all other financial instruments in that country-as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options, and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit.

Foreign-Exchange Risk

When investing in foreign countries, it's important to consider the fact that currency exchange rates can change the price of the asset as well. Foreign exchange risk (or exchange rate risk) applies to all financial instruments that are in a currency other than your domestic currency.

As an example, if you live in the U.S. and invest in a Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the U.S. dollar.

Interest Rate Risk

Interest rate risk is the risk that an investment's value will change due to a change in the absolute level of interest rates, the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship. This type of risk affects the value of bonds more directly than stocks and is a significant risk to all bondholders. As interest rates rise, bond prices in the secondary market fall-and vice versa.

Reinvestment risk is related to interest rate risk. It is the possibility that an investor may not be able to reinvest the cash flows received from an investment (such as interest or dividends) at the same rate of return as the original investment. Reinvestment risk is particularly relevant for fixed income investments like bonds, where interest rates may change over time. Investors can manage reinvestment risk by laddering their investments, diversifying their portfolio, or considering investments with different maturity dates.

Political Risk

Political risk is the risk an investment's returns could suffer because of political instability or changes in a country. This type of risk can stem from a change in government, legislative bodies, other foreign policy makers, or military control. Also known as geopolitical risk, the risk becomes more of a factor as an investment's time horizon gets longer.

Counterparty Risk

Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions, especially for those occurring in over-the-counter (OTC) markets. Financial investment products such as stocks, options, bonds, and derivatives carry counterparty risk.

Liquidity Risk

Liquidity risk is associated with an investor's ability to transact their investment for cash. Typically, investors will require some premium for illiquid assets which compensates them for holding securities over time that cannot be easily liquidated.

This type of risk arises from the use of financial models to make investment decisions, evaluate risks, or price financial instruments. Model risk can occur if the model is based on incorrect assumptions, data, or methodologies, leading to inaccurate predictions and potentially adverse financial consequences. Model risk can be managed by validating and periodically reviewing financial models, as well as using multiple models to cross-check predictions and outcomes.

Risk vs. Reward

The risk-return tradeoff is the balance between the desire for the lowest possible risk and the highest possible returns. In general, low levels of risk are associated with low potential returns and high levels of risk are associated with high potential returns. Each investor must decide how much risk they're willing and able to accept for a desired return. This will be based on factors such as age, income, investment goals, liquidity needs, time horizon, and personality.

The following chart shows a visual representation of the risk/return tradeoff for investing, where a higher standard deviation means a higher level or risk-as well as a higher potential return.

It's important to keep in mind that higher risk doesn't automatically equate to higher returns. The risk-return tradeoff only indicates that higher risk investments have the possibility of higher returns-but there are no guarantees. On the lower-risk side of the spectrum is the risk-free rate of return -the theoretical rate of return of an investment with zero risk. It represents the interest you would expect from an absolutely risk-free investment over a specific period of time. In theory, the risk-free rate of return is the minimum return you would expect for any investment because you wouldn't accept additional risk unless the potential rate of return is greater than the risk-free rate.

Risk and Diversification

The most basic-and effective-strategy for minimizing risk is diversification. Diversification is based heavily on the concepts of correlation and risk. A well-diversified portfolio will consist of different types of securities from diverse industries that have varying degrees of risk and correlation with each other's returns.

While most investment professionals agree that diversification can't guarantee against a loss, it is the most important component to helping an investor reach long-range financial goals, while minimizing risk.

There are several ways to plan for and ensure adequate diversification including:

1. Spread your portfolio among many different investment vehicles-including cash, stocks, bonds, mutual funds, ETFs and other funds. Look for assets whose returns haven't historically moved in the same direction and to the same degree. That way, if part of your portfolio is declining, the rest may still be growing.

2. Stay diversified within each type of investment. Include securities that vary by sector, industry, region, and market capitalization. It's also a good idea to mix styles too, such as growth, income, and value. The same goes for bonds: consider varying maturities and credit qualities.

3. Include securities that vary in risk. You're not restricted to picking only blue-chip stocks. In fact, the opposite is true. Picking different investments with different rates of return will ensure that large gains offset losses in other areas.

Keep in mind that portfolio diversification is not a one-time task. Investors and businesses perform regular "check-ups" or rebalancing to make sure their portfolios have a risk level that's consistent with their financial strategy and goals.

Can portfolio diversification protect against risks?

How does investor psychology impact risk-taking and investment decisions?

How do "black swan" events relate to risk management, and how can investors prepare for them?

The Bottom Line

We all face risks every day-whether we're driving to work, surfing a 60-foot wave, investing, or managing a business. In the financial world, risk refers to the chance that an investment's actual return will differ from what is expected-the possibility that an investment won't do as well as you'd like, or that you'll end up losing money.

The most effective way to manage investing risk is through regular risk assessment and diversification. Although diversification won't ensure gains or guarantee against losses, it does provide the potential to improve returns based on your goals and target level of risk. Finding the right balance between risk and return helps investors and business managers achieve their financial goals through investments that they can be most comfortable with.

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Risk: What It Means in Investing, How to Measure and Manage It

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Risk takes on many forms but is broadly categorized as the chance an outcome or investment's actual return will differ from the expected outcome or return.