Putting all your eggs (investments) in one basket (asset class) puts you at risk if this asset class does not perform well. By diversifying across asset classes, you reduce your risk to any one asset class. Historically, the different asset classes have tended to perform well at different times and according to different cycles. When one is underperforming another might do well. This helps to avoid your whole portfolio taking a downturn and smoothing out the returns across your portfolio.
Diversifying across investment styles can further mitigate this risk.
This is risk that inflation will increase at a faster rate than your investment returns. This reduces the ‘real’ value of your investment portfolio which could impact you achieving your financial goals. Investing in assets such as shares and property can help to reduce this risk through exposure to capital growth.
Fund Manager Risk
It’s important you not only diversify across asset classes but Fund Managers too. This way, your exposure to any one manager is limited if/when a fund manager underperforms.
This is risk that the currency exchange rate will adversely impact your investment portfolio returns. Some managed funds provide internal ‘hedging’ to manage this risk on your behalf. If you are investing directly into other countries, you can use derivatives and other ‘hedging’ strategies to mitigate this risk. Diversification broadly across the globe will also help to reduce your exposure to any one currency.
Liquidity is access to cash and investing carries some risk of not having access to your funds when you need it. It is always a good idea to have an emergency cash reserve to meet this need. If you do require access to managed funds, some can take 3-4 weeks to process and pay redemptions and this time frame should be factored into your investment plan. Other private or off-market investments may not have liquid secondary markets so make sure you understand and plan for this lack of access.
Market risk applies more broadly to the wider market rather than individual asset classes and may relate to scenarios such as regulatory or political changes, economic environment, natural disasters, pandemics and market sentiment. This will impact your investment portfolio as a whole and is difficult to mitigate as a risk. Investing through managed funds may help to reduce this risk with the research and expertise of professionals monitoring these influences on the market.
Market Timing Risk
Timing risk is where you may buy an investment or shares when the price is high or sell when the price is particularly low. This can greatly impact short term returns but investing for the long term can help smooth out these price differentials.
Interest Rate Risk
An increase or decrease in interest rates may adversely impact your investment returns. Derivatives can be used to manage this risk on larger investment transactions and holdings, although there are costs associated with these risk management tools.
A strategy using derivatives to help reduce the risk of an investment portfolio. This can be done by holding derivatives in positions that counter risk such as price points on a share price. There are costs associated with derivatives and these should be weighed up against the potential value of the risk management strategy.
Although derivatives are often used as a risk management tool, strategies to hold them as an alternative to holding the underlying asset have their own risks. The derivative value may reduce to zero, it may not correlate to the movement of the underlying asset or, the cost might outweigh the benefit or return it provides.