Understanding Investment Risk

Investment risk is the possibility that an investment produces a negative financial outcome or otherwise harms an investor’s financial welfare. Risk is not limited to a temporary change in price: it can include different ways an investment may fail to meet an investor’s financial needs. All investments involve some degree of risk, and an investment can lose part or all of its value.

Investment risk can come from several sources. Market risk is the possibility that broader market conditions affect value. Business risk relates to problems involving a company or issuer. Liquidity risk concerns difficulty related to accessing or selling an investment. Inflation risk is the risk that inflation affects the value of money or an investment outcome. Currency and political risks can matter especially for international investments. Concentration risk arises when too much is invested in one holding or area. These risks can overlap, and an investment may face more than one of them at the same time.

A common general tradeoff is that higher potential returns are associated with greater potential risk. This is not a promise: a riskier investment is not guaranteed to earn a higher return. Asset allocation means dividing investments among asset classes such as stocks, bonds, and cash. An appropriate allocation depends partly on an investor’s time horizon and risk tolerance. Diversification means spreading investments across different investments or asset classes to reduce exposure to any one investment or concentration risk. These approaches manage exposure to risk; they do not make an investment risk-free.