Basics of Investing(Part 4)

 What is risk? We started this series by asking What Investing Is? 

Why you would want to invest in the first place?

 And then teasing you about the upside potential of compounding returns. And now it's time for arguably the most important part of our series on investing Risk.

In general terms Risk is the possibility of loss or injury and let's use a non-investing example to unpack this simple but important definition.

We can relate this back to investing in a second. If you are driving in a car and speeding on the highway and weaving through traffic.

You know that the possibility of getting into an accident is higher than going with the flow of traffic and minimizing unnecessary lane changes assuming drivers of equal skill and equipment.

And I say that because we all know too well that just because someone is driving at the flow of traffic doesn't guarantee that they have any business behind the wheel of a car.

Anyways, if you crashed then you might suffer a loss or injury and the severity of that crash is often higher when the speed at which you are driving is faster. 

So, going back to our general definition risk is the possibility of loss or injury we see that we can increase risk in two main ways: The possibility of loss or injury can go up and the amount of loss or injury that can possibly occur can go up as well. 

So, this is a pretty good framework for risk in general. But when it comes to finance and investing, risk has a number of ways in which it shows up. I'm going to very quickly give you a list of some of the different types of risks that you might hear about.

But keep in mind that this list contains a lot of investing 201 type material. So, don't worry if some of this sounds complex. This list here is mostly good to know but not necessarily need to know at this stage for this series on learning about investing.

Here I’m sharing a small list of different types of risk you might hear about when it comes to investing.

• Credit or Default Risk
• Currency risk or Foreign Exchange Risk
• Interest rate Risk
• Reinvestment Risk
• Political Risk
• Inflation Risk
• Longevity Risk and
• Market Risk

 Now, this list is not exhaustive but each type of risk exhibits two basic characteristics you should be looking for -

1. The possibility or probability of an injury or loss and
2. The nature of what that specific injury or loss looks like

Let's take a look at credit risk as an example to identify these two aspects. Credit risk or Default risk is the risk that someone who has borrowed money isn't able to make their scheduled repayment according to schedule.

Now you may be familiar with the concept of a credit score. The higher your credit score the less of a risk you look like to a lender. If you were to pay your credit card bill late one time your credit score might drop a few points.

If you were to not make payments on your credit card for a few months in a row your credit score would drop significantly. So, with credit risk the specific injury or loss is not making repayments according to schedule.

It can be small if it's just one payment missed by a few days or it could be large if the borrower goes bankrupt and can't make any more repayments. The possibility or probability of this happening depends on who is borrowing the money.

If the person borrowing the money has a lot of assets a high income and a very stable job and no other debts. It's fairly unlikely that they will miss payment.

But if the person borrowing the money has five maxed out credit cards a car loan, student loan, a big mortgage and an unstable job with low income they are more likely to miss a payment.

Okay, so now we have a framework for what risk is in general. But in the next post we are going to turn our focus to risk as it pertains to investing for most people which essentially is all about the risk of losing money.

Different types of investments have different amounts of risk. That means that the degree of losses can vary as well as how often these varying degrees of losses can occur.

Thanks for reading this article.

Click here if you want to read the previous parts.