when investing in foreign countries it s important to consider the fact that currency exchange rates can change the price of the asset as well foreign exchange risk or exchange rate risk applies to all financial instruments that are in a currency other than your domestic currency 10
as an example if you live in the u s and invest in a canadian stock in canadian dollars even if the share value appreciates you may lose money if the canadian dollar depreciates in relation to the u s dollar interest rate risk is the risk that an investment s value will change due to a change in the absolute level of interest rates the spread between two rates in the shape of the yield curve or in any other interest rate relationship this type of risk affects the value of bonds more directly than stocks and is a significant risk to all bondholders 10 as interest rates rise bond prices in the secondary market fall and vice versa reinvestment risk is related to interest rate risk it is the possibility that an investor may not be able to reinvest the cash flows received from an investment such as interest or dividends at the same rate of return as the original investment reinvestment risk is particularly relevant for fixed income investments like bonds where interest rates may change over time investors can manage reinvestment risk by laddering their investments diversifying their portfolio or considering investments with different maturity dates political risk is the risk an investment s returns could suffer because of political instability or changes in a country this type of risk can stem from a change in government legislative bodies other foreign policy makers or military control 10 also known as geopolitical risk the risk becomes more of a factor as an investment s time horizon gets longer counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation counterparty risk can exist in credit investment and trading transactions especially for those occurring in over the counter otc markets financial investment products such as stocks options bonds and derivatives carry counterparty risk 11liquidity risk is associated with an investor s ability to transact their investment for cash 10 typically investors will require some premium for illiquid assets which compensates them for holding securities over time that cannot be easily liquidated this type of risk arises from the use of financial models to make investment decisions evaluate risks or price financial instruments model risk can occur if the model is based on incorrect assumptions data or methodologies leading to inaccurate predictions and potentially adverse financial consequences model risk can be managed by validating and periodically reviewing financial models as well as using multiple models to cross check predictions and outcomes risk vs rewardthe risk return tradeoff is the balance between the desire for the lowest possible risk and the highest possible returns in general low levels of risk are associated with low potential returns and high levels of risk are associated with high potential returns 1 each investor must decide how much risk they re willing and able to accept for a desired return this will be based on factors such as age income investment goals liquidity needs time horizon and personality the following chart shows a visual representation of the risk return tradeoff for investing where a higher standard deviation means a higher level or risk as well as a higher potential return it s important to keep in mind that higher risk doesn t automatically equate to higher returns the risk return tradeoff only indicates that higher risk investments have the possibility of higher returns but there are no guarantees on the lower risk side of the spectrum is the risk free rate of return the theoretical rate of return of an investment with zero risk it represents the interest you would expect from an absolutely risk free investment over a specific period of time in theory the risk free rate of return is the minimum return you would expect for any investment because you wouldn t accept additional risk unless the potential rate of return is greater than the risk free rate risk and diversificationthe most basic and effective strategy for minimizing risk is diversification diversification is based heavily on the concepts of correlation and risk 12 a well diversified portfolio will consist of different types of securities from diverse industries that have varying degrees of risk and correlation with each other s returns while most investment professionals agree that diversification can t guarantee against a loss it is the most important component to helping an investor reach long range financial goals while minimizing risk there are several ways to plan for and ensure adequate diversification including keep in mind that portfolio diversification is not a one time task investors and businesses perform regular check ups or rebalancing to make sure their portfolios have a risk level that s consistent with their financial strategy and goals 9can portfolio diversification protect against risks portfolio diversification is an effective strategy used to manage unsystematic risks risks specific to individual companies or industries however it cannot protect against systematic risks risks that affect the entire market or a large portion of it systematic risks such as interest rate risk inflation risk and currency risk cannot be eliminated through diversification alone however investors can still mitigate the impact of these risks by considering other strategies like hedging investing in assets that are less correlated with the systematic risks or adjusting the investment time horizon 