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What are the risks of investing

What are the risks of investing

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Investing is one of those things that commands respect. On the one hand there are doubts about your own financial knowledge and, on the other, our natural aversion to loss (losing hurts 2.5 times as much as an equivalent gain).

Summed up in one word: fear. The fear of failure and losing everything, which is a possibility, but just as likely as a piano falling off a balcony onto your head.

Every time you invest you risk losing. This is an undeniable reality. The problem is that our brain tends to overvalue that option as behavioral economics has shown. The solution? Be aware of the risks of the investment and learn to control them.

Classical economic theory recognizes these issues, but before we get to that, there is an additional and more personal pitfall. This is the mistake that most savers make: not getting your risk profile right by over- or under-assessing your possibilities.

What is your risk profile

Your investor profile measures your risk tolerance and should be tailored to your financial goals and time horizon, your financial situation (how much savings and income you have), your investment knowledge and experience, and your tolerance for potential downturns in your investments.

Depending on these four factors, your profile will be more or less risky. In fact, the first and last are the most important. The first, because if you invest for the long term, you will be able to take on more risk, and the last because this helps you to understand how you will behave when you make a loss.

It is very common to make a mistake with your profile by being too cautious if you have a high aversion to loss, or by being overly optimistic. With the first mistake, only your profitability will be affected, with the second, your entire plan may be damaged.

This risk profile is what you will build your entire investment plan around, how you allocate your investments and the overall risk of your portfolio.

If you are too optimistic and take on more risk than you can actually bear (and it doesn’t have to be much), you will sell when there are downturns and you may never invest again. So, of all the risks of investing, the biggest is not knowing yourself and your tolerance for volatility (the ups and downs of your investments, which will always be there).

Investment Risks

Beyond your profile as an investor, there are a series of risks inherent to any investment. These are the following:

Market risk

Also called systemic or non-diversifiable risk, these are risks affecting the market as a whole, such as a pandemic, a major economic crisis or a war.

Protecting against these risks is complicated and the only way to do so is to use investment tools that do not work in the same market. For example, investing in the stock market and in the real estate market, or in crowdfunding platforms for lending to unlisted companies.

Each of these investments has its own market risks. The key is that all three are different: what affects the stock market may not affect the rent you charge for a house or a loan to a SME. Even if it does affect them, it is likely to do so at different times (the stock market goes down today because of a crisis, but an SME won’t really suffer for months).

Non-systemic risk

This is the particular risk of each asset in which you invest. For example, if you invest in a specific company, it is the risks specific to that company due to the sector in which it operates or the countries in which it is located.

The way to avoid this risk is to diversify your investments across different sectors, companies and assets. In addition, you should look for a certain decorrelation between these assets. In other words, investments that do not behave in the same way when faced with the same stimulus. For example, fixed income and equities, where when one rises, the other usually does not.

Liquidity risk

One of the most important factors when assessing the risk of any investment, liquidity is the ease with which you can get your money back at any time if you need it.

In other words, if you want to sell your stake in the company or fund, you can find someone willing to buy it. We tend to take this liquidity for granted, but it is not always the case. Imagine, for example, that you have invested in an unlisted start-up. You won’t be able to pull out of it until someone buys your shares. In regulated markets such as the stock exchange, the market itself is responsible for (partially) guaranteeing this liquidity.

In addition, some products and markets are more liquid than others. For example, with a pension plan you will have to wait 10 years to recover your investment, whereas with a mutual fund you can do this at any time.

Legislative risk

As its name suggests, this is the risk that laws change and affect your investments. This affects both the companies in which you invest and investment products in general.

This is precisely what has happened to pension plans in the face of the cut in the maximum deductible amount in 2022, or what may happen if certain tax advantages specific to investment funds are withdrawn.

Added to these risks are others such as currency risk if you invest in companies or assets that are not listed in euros (an American company, for example), and two systemic risks: inflation risk when inflation rises above your investments; and interest rate risk, which is outside your control.

Not all risks affect all products or investments equally. For example, already diversified investment tools, such as funds, cope better with systemic and non-systemic risk. In this article we tell you which investment products to choose according to your risk profile.

In any case, remember that investing has its risks, but the risks of not doing so are even greater.