What Risks Are Involved in Investing?

We are afraid to invest. Unjustifiably. The main cause is fear of possible loss. It arises because the world of financial markets is mostly unknown to many of us. We naturally try to avoid things we don't understand, as we can't predict their impact on our lives. These feelings are completely natural.

As I said, investing is one such unknown. The perception of risk is very misleading and incorrect among small investors. We are afraid of things that do not pose a long-term problem for our investments and, on the contrary, overlook the factors that represent real threats to our wealth.

To successfully appreciate our wealth and stop having nightmares about money, we must understand the risk connected to investing and account for it. Risk is not a reason to avoid investing. Despite the existence of risk, investing is the best and easiest way to appreciate savings and build long-term wealth. The numbers don't lie.

Risk is nothing exceptional, nor should it be perceived as an enemy. It is a natural price for higher returns. Risk is an integral part of investing and every investor must learn to live with it.

Returns and risk are best friends, they go hand in hand and their relationship has never been broken in a substantial or long-term way. If you want to appreciate your assets, you have to take risks. If you are not willing to take risks, your returns will remain low and inflation will erode the value of your savings.

Money does not grow on a tree and there is no such thing as a free lunch in the real world. Investments must earn returns by capitalizing on their business earnings. Every business brings uncertainty.

Investment managers are not magicians who can create returns out of thin air. Profits must come from something and interest must be paid from something, usually only from the company's income, i.e. the sale of goods or services. Always bear this in mind when considering any investment.

Risks need not be feared and should be seen as a concession for long-term above-average profits. Risk can be managed. There are certain fundamental investing rules which describe ways to reduce it. If you follow these rules, you won't have to worry about investment risk anymore.

Risk is generally defined as the uncertainty over the achievement of your investment goals. In other words, it is the probability of generating desired returns by a specific investment.

Every proper investment process begins with the definition of an investment goal. This may sound trivial, but it will help you avoid disappointment later on. Every goal, including the investment one, is reachable in several ways, but each of those ways carries a certain amount of risk, i.e. a different chance of arriving at the destination.

The first and one of the most important risk management methods that should be used even before getting started with investing is choosing the right portfolio composition. Investments should be tailored to their goals, its parameters, conditions, and the investor's character (investment horizon, financial situation, expected returns, and risk tolerance).

Based on them, the investor chooses the right investment composition (allocation), i.e. the proportion of different asset classes carrying different risk and return profiles. In general, bonds are a safer investment with less violent price fluctuations, but also with lower long-term returns. Contrarily, equities are a more volatile investment with higher long-term returns.

Of course, investors should keep their feet on the ground, setting realistic, and achievable expectations. The probability of achieving the investment goal with the chosen allocation should be as high as possible. That is to say, it should keep its risk as low as possible.

Government bonds of developed countries (especially the USA, Japan and Germany) are considered to be risk-free investments in the financial world. Bank deposits of individuals up to 100 thousand euros are also considered to be risk-free investments, as they are guaranteed by the state's deposit insurance.

However, their yields also correspond to low risk. German 10-year government bond today offers a negative yield of -0.2% per annum, i.e. that investors are paying the largest European economy for borrowing their money. Deposits in banks offer practically zero interest today.

If your target is to at least outperform inflation with the investment's return, you have no choice but to take risk. In general, any return above the risk-free investment level carries some degree of risk.

We divide investment risks into two basic groups:

• Non-systemic risks (specific)
• Systemic risks (market)

Specific Risks

This group includes the individual subjective risks relating to a particular security and its issuer (issuer - a company or a state). It is specifically related to the business to which you lend money through the purchase of a bond or in which you invest by buying shares. Risks connected to specific investors or their investment managers also belong in this category.

Business risk is the most common risk of an individual security. This may be any event or cause that hinders the company’s expected economic results or depresses its value.

Examples are low quality of products or services, weak demand for them, high expenses, weak market share, adverse industry development, company management, bad accounting or business strategy, failure to achieve plans, scandals, violations of law, lack of innovation, and anything else that lowers the company's earnings, profitability or leads to the sale of shares by investors and declines in the value of the company.

A certain subset of business risk is credit risk that is only applicable to bonds and other debt securities. Credit risk is the probability that the entire principal of the bond or some of its coupon interest will not be paid out.

The causes of failing to make the promised payments are similar as before. Each debtor borrows money to invest them in a business, which must in turn generate enough money to allow for the return of principal along with the agreed interest. A failure to do this results in the materialization of credit risk.

The most effective method of minimizing or even eliminating business risk is broad diversification. This means distributing the investment over a large number of individual securities.

Business risk can also be eliminated by thorough and fundamental investment analysis and the application of an effective investment strategy, but as history and experience show, their effect is not sufficient and carries other specific risks.

These are human risks and investment strategy risks. Although most of us deny it, we are mainly driven by our emotions, which harms our investments. We think that our decision-making is rational, but it is primarily controlled by the psyche.

Emotions make human decisions prone to errors, which ultimately causes actively managed investments to achieve a weaker long-term performance compared to market development. This also applies to professional investment managers who aren't immune to these mistakes. This is perhaps the most underestimated and the most significant investment risk.

The solution to business risk or similar specific risks may be following a specific investment strategy. However, no strategy is universal. Each one works under certain conditions, but lags behind or brings greater risk in others.

The most effective way of eliminating human risk is investing passively, i.e. holding the entire market without actively selecting securities or trying to buy and sell investments at the right time.

Systemic Risks (Market)

This is an objective, general risk arising from the development of society, stock markets, and the economy. Investors do not have the power to influence it significantly. Economic cycles (alternations of expansions and corrections) are natural.

Systemic risks can include general market sentiment affecting index movements, macroeconomic developments, as well as political risks (on currency and fiscal levels). Related and more specific risks are currency, inflation, and interest rate risks.

Market risks can be described as natural and completely unavoidable. In reality, they are the least harmful risks to your investment, as long as you follow the basic investment rules. Paradoxically, systemic risks often concern us to a much greater extent than other risks.

Time always takes care of market risk, gradually decreasing it to zero as the investment horizon increases. Financial markets have recovered from each recession, eventually reaching new highs. Sufficient time is a fundamental and the most important condition for successful investing.

As Pavel Škriniar from the University of Economics in Bratislava says: “Investing is like baking a cake. You will not take it out of the oven after 5 minutes and eat the cake unfinished. Similarly, you have to be patient with your investments and let them stay in the oven for the time required, not eating them before the horizon passes.”

Fluctuations in our investment's value causes us to be anxious. We are worried that the prices of securities in our portfolios might fall. But the fact that they are aggressively traded actually represents a huge advantage. It allows you to always react quickly to changes in your life situation or to change the investment itself.

At any time, you can sell or buy an additional investment, being certain that it is fairly valued at any moment by a huge number of market participants. Because of this, you always know how the market perceives your investment.

In contrast, we subconsciously and erroneously prefer non-volatile investments, such as private bond issues. But which investment carries more risk? Investing in the 5,000 largest global companies with trillions in earnings from the entire world, or a loan to a local apartment building company with minimal capital and zero assets?

The 5,000 biggest companies will not disappear from the world map. With a sufficiently diversified investment, you can never lose everything and the decline in value is always temporary. But once the apartment company you lent money to goes bankrupt and doesn't pay out the bond payments, no one will be able to return the lost money to you. So, which one is riskier?

Another useful market risk management tool is the right allocation (portfolio composition) already mentioned at the beginning. Unless I am willing to bear the risk and cope with portfolio fluctuations, I cannot expect high returns. Similarly, if I am not able to give the investment sufficient time, I shouldn't invest dynamically.

But these are no reasons to avoid investing. We can invest with different risks. Portfolios with a higher proportion of bonds are suitable for shorter periods and for more cautious investors because they have significantly lower value volatility. This can be seen in the following graph.

It is also advisable to deal with market risk by investing regularly. Because of this, the purchase prices will average out in time, allowing us to buy more shares during market declines and increase our wealth.

Other market risks, such as currency, political, and interest rate risk are also effectively eliminated by sufficient diversification.

What Risks Do You Take With Finax?

When we founded Finax, we had a wealth of experience in investments and financial markets. We used this experience to create the Intelligent Investing portfolios. We have not turned our back on the risk, as it is as an integral part of any investment.

Portfolios have been designed with great emphasis on minimizing the vast majority of risks:

• business risk and credit risk are virtually zero – Finax portfolios are exceptionally well-diversified, containing 9.5 thousand stocks and bonds from all sectors of the economy,
• passive investing, which Finax strategies embody, completely removes any human and investment strategy risks,
• broad diversification across securities from 92 countries on all continents significantly reduces political and currency risks,
• you do not have to worry about choosing the right allocation based on your goals, risk profile, or horizon - our platform will select the appropriate portfolio that will suit your goals and involve the right amount of risk,
• invest monthly, starting at just € 10 – all you need to do is set up a standing order,
• the only risk left is the market risk that can be eliminated by stretching your investment over a sufficient time horizon,
• afterwards, all you have to do is correctly assess your life situation, plans, expectations, and character, give at least a portion of your savings enough time to work, maintain discipline, and avoid giving in to emotions before the set horizon passes.

The ideal investment achieves a maximum return with minimal risk. We are convinced that our portfolios meet this criterion.

In the upcoming months, we will continue to publish more articles and webinars about the proper setup and management of personal finances, investment plans, as well as the risks of various types of investments.

If you want to invest with minimal risk and get the most out of it, transfer your investments to Finax and get a discount - 50% of the transferred amount will be managed at no charge for 2 years.