Market risk is the risk inherent in the broad financial market itself. Let’s say you invest in the stock market and have a well-diversified portfolio. No matter how carefully you pick your stocks, if the stock market goes down, so too will your investments. Numerous factors contribute to overall market risk — political and geopolitical volatility, interest rate changes, currency fluctuations and changes in commodity prices.
As market risk affects an entire market, one way to manage this risk is to diversify your investments across different regions or sectors to spread out your risk.
Credit or business risk is a specific risk — also called unsystematic risk – that affects a small number of assets. It is the risk that a company or government you invest in might fail; this is opposed to market risk, which is systematic and affects an entire market. A company listed on the stock exchange might go out of business, rendering its stock worthless.
In the bond market, a company may default on its bonds (as bonds are essentially loans taken from the market). This would mean its bondholders, i.e. its creditors, may have to take a loss. That is why government bonds, particularly those of developed nations, are generally considered to have very low credit risk, making them safe haven assets.
Of course, in general, the lower the credit risk of a counterparty, the lower the potential returns, so you may want to weigh your risk appetite against the returns you would like to make.
An investment’s liquidity reflects the ease with which the owner is able to sell it off in the market. Before an investment is sold, any gains or losses are only on paper, or unrealised.
Let’s say you have invested in a piece of property. Even if the market value of that property rises significantly above your purchase price, your profit is merely a paper gain as long as the property is unsold.
Therefore, liquidity is something you should always bear in mind. Certain asset classes such as stocks are far more liquid than others like real estate. Investing in illiquid assets comes with a higher risk as you may not be able to sell your investments as quickly.
Even within asset classes, liquidity levels can vary; for instance, some stocks are easier to sell than others. One simple way to check a stock’s liquidity is to study its average daily trading volume, which is the average number of shares that are traded in a day. Generally, the higher this number, the more liquid the stock is.
Given that the market moves in cycles, the timing of your market entry can have a big impact on your financial return. Entering during a bear market and exiting during a bull market is far better than the other way around. But timing the market could be difficult simply because there are too many influencing factors to account for.
However, you can mitigate timing risk via time horizons — how long you intend to hold your investments for. Investing for the long term will smoothen out shorter-term fluctuations and allow you to gain from the overall underlying trend. A good example of this is the stock market. The S&P 500 has fluctuated significantly but its value has just about doubled over the past 20 years.
You can also mitigate this risk through dollar-cost averaging (find out how here).
Intelligent investing goes a long way towards helping you achieve your financial goals. And the first step is understanding the main risks that come with investing so that you can be better equipped to manage them.
To find out more about Standard Chartered’s range of investment products and how they fit in with your financial goals, speak to one of our financial advisors today. Get in touch with us.