In personal finance, few terms are as important – or as ubiquitous – as the word risk. Yet, few terms are also as imprecise. Typically, when financial advisors or pundits talk about investment risk, their focus is on the historical price volatility of an asset or investment.

What is the definition of risk?

Generally, risk refers to the overall likelihood that your investment will provide lower returns than expected or that you may lose the entire investment. It’s important to remember that every investment, whether labeled as risky or conversative, still carries some degree of risk, including the possible loss of principal. That’s why it makes sense to understand the kinds of risks that exist in personal finance, how to manage them, and how your individual risk tolerance can inform your investment strategy.

Here are a few of the many different types of risk:

  • Volatility risk. This refers to unpredictable price swings in the value of a stock or in the market at large. Lower-volatility investments are generally more suitable for short-term investments, while higher-volatility investments are better suited for longer-term investment horizons.
  • Market risk. This term refers to the possibility that an investment will lose value because of a general decline in financial markets due to one or more economic, political, or other factors.
  • Inflation risk. Sometimes known as purchasing power risk, this term refers to the possibility that prices will rise in the economy as a whole, so your ability to purchase goods and services would decline. Inflation risk is often overlooked by fixed income investors who shun the volatility of the stock market completely.
  • Interest rate risk. This term relates to increases or decreases in prevailing interest rates and the resulting price fluctuation of an investment, particularly bonds. There is an inverse relationship between bond prices and interest rates. If you need to sell a bond before it matures and interest rates are higher than when you purchased the bond, you run the risk of losing some of your principal.
  • Reinvestment rate risk. This term refers to the possibility that funds might have to be reinvested at a lower rate of return than that offered by the original investment. For example, a five-year bond with a 3.75 percent yield might mature at a time when an equivalent new bond pays only 3 percent.
  • Default risk. Also called credit risk, this term refers to the risk that a bond issuer will not be able to pay its bondholders interest or repay principal.
  • Liquidity risk. This term refers to how easily your investments can be converted to cash. Occasionally, this term may also refer to how easily your investments can be converted to cash without loss of principal.
  • Political risk. This term refers to the possibility that new legislation, policy changes, or changes in foreign governments will adversely affect the U.S. or global capital markets, specific industries, or specific companies you invest in.
  • Currency risk. For those making international investments, this term refers to the possibility that the fluctuating rates of exchange between U.S. and foreign currencies will negatively affect the value of a foreign investment, as measured in U.S. dollars.

In general, the more risk you’re willing to take on, the higher your potential returns and your potential losses. People are wired to avoid risk. Yet the potential for higher investment returns often becomes incentive to make a higher-risk investment. That is the trade-off. As an investor, your goal is to maximize your returns without taking on an inappropriate level or type of risk.

Before making an investment decision, aim to become fully informed about each investment product. Speaking with a financial advisor can be a good idea. Advisors can provide helpful perspective on individual investments and asset classes and can help you understand how your personal risk tolerance can impact your financial plan and your financial goals.

Source: Broadridge Investor Communication Solutions, Inc.