Every investment carries some level of risk. Whether you’re investing for retirement, saving for a major purchase, or building long-term wealth, understanding risk is one of the most important parts of making informed financial decisions.
While many investors think of risk simply as the possibility of losing money, investment risk is more complex than that. Different types of risk affect investments in different ways, and understanding those differences can help you make more thoughtful decisions and stay focused during periods of market volatility.
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This blog is based on the attached educational resource guide, Understanding Risk from Different Angles, written by Larry Adam who joined Raymond James in 2018 as Chief Investment Officer.
What Is Investment Risk?
Investment risk is the possibility that an investment’s actual return will differ from what you expect. Sometimes that means an investment may temporarily lose value. Other times, it could result in more significant or permanent losses if an investment is sold before it has an opportunity to recover.
Although risk cannot be completely eliminated, understanding the sources of risk can help investors build portfolios that align with their financial goals, investment timeline, and comfort level with market fluctuations.
Rather than avoiding risk altogether, successful long-term investing often involves learning how to manage it.
The Two Primary Types of Investment Risk
Financial professionals generally group investment risk into two broad categories: systematic risk and unsystematic risk. Together, they make up the total risk within a portfolio.
Systematic Risk
Systematic risk, sometimes called market risk, affects broad segments of the financial markets. Because these events influence many investments at the same time, they cannot be eliminated through diversification.
Examples of systematic risk include:
- Changes in interest rates
- Inflation Economic recessions
- Geopolitical events
- Changes in monetary policy
- Broad market volatility
These events may cause stock and bond prices to rise or fall across entire markets, regardless of how well individual companies are performing.
Unsystematic Risk
Unsystematic risk is unique to a specific company, industry, or investment.
Examples include:
- Changes in company leadership
- Product failures
- Competitive pressures
- Industry-specific regulations
- Legal or operational challenges
Unlike market risk, unsystematic risk can often be reduced through diversification. Owning investments across multiple companies, industries, and asset classes helps limit the impact that any one investment may have on an overall portfolio.
Why Investment Losses Matter
One of the most overlooked aspects of investing is that recovering from a loss requires a larger percentage gain than the amount originally lost.
For example:
- A 10% decline requires approximately an 11% gain to recover.
- A 20% decline requires a 25% gain.
- A 50% decline requires a 100% gain just to return to the original value.
This relationship illustrates why managing risk is just as important as seeking investment returns. Larger losses not only require greater future gains, but they may also extend the amount of time needed for a portfolio to recover.
Understanding this relationship can help investors appreciate the value of maintaining a disciplined investment strategy rather than making emotional decisions during periods of market volatility.
Diversification Helps Manage Risk
Diversification is one of the most widely used risk management strategies in investing.
Instead of concentrating investments in a single company or industry, diversification spreads investments across different asset classes, sectors, and geographic regions.
While diversification cannot eliminate market risk or prevent losses during broad market declines, it may help reduce the impact of company-specific risks and improve the overall balance of a portfolio.
For many investors, diversification is an important component of a long-term investment strategy.
Staying Focused During Market Volatility
Market declines can be uncomfortable, especially when headlines focus on uncertainty or negative economic news.
History has shown that markets experience periods of volatility as a normal part of investing. While no one can predict exactly when markets will decline or recover, investors who make decisions based solely on short-term market movements may unintentionally interfere with their long-term financial goals.
Having an investment strategy based on your objectives, time horizon, and risk tolerance can help provide perspective during periods of uncertainty.
Working with a financial advisor may also help investors evaluate market events within the context of their overall financial plan rather than reacting to short-term fluctuations.
Key Risks and Considerations
Every investment strategy involves some level of risk. Important considerations include:
- All investments may lose value.
- Diversification helps manage certain risks but cannot eliminate losses or guarantee positive investment returns.
- Market declines are a normal part of long-term investing.
- Larger investment losses generally require proportionately larger gains to recover.
- Investment decisions should align with your financial goals, time horizon, and tolerance for risk.
Building Your Understanding
Several investing concepts are closely related to understanding investment risk:
- Risk Tolerance — The amount of market fluctuation an investor is comfortable accepting while pursuing financial goals.
- Asset Allocation — The process of dividing investments among stocks, bonds, cash, and other asset classes to balance growth potential and risk.
- Diversification — Spreading investments across multiple securities, industries, and asset classes to help reduce company-specific risk.
- Market Volatility — The normal movement of investment prices as markets respond to economic conditions, investor sentiment, and new information.
- Time Horizon — The length of time an investor expects to remain invested before needing the money. Longer time horizons often provide greater opportunity to recover from temporary market declines.
Understanding these concepts can help investors make more informed decisions and maintain confidence during changing market conditions.
Related Investment 101 Articles
- What Is a Stock?
- What Drives the Stock Market? Understanding Equity Fundamentals
- How Do Returns and Consistent Contributions Affect Portfolio Growth?
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Frequently Asked Questions
What is investment risk?
Investment risk is the possibility that an investment’s actual return will differ from expectations, including the potential for temporary or permanent loss of value.
What is the difference between systematic and unsystematic risk?
Systematic risk affects the overall market and cannot be eliminated through diversification. Unsystematic risk is specific to an individual company or industry and may be reduced by holding a diversified portfolio.
Why is diversification important?
Diversification helps reduce the impact of company-specific risks by spreading investments across multiple securities, industries, and asset classes. However, it cannot eliminate market risk or guarantee profits.
Why do larger losses require bigger gains to recover?
Percentage gains are calculated from a lower starting value after a loss. For example, recovering from a 50% decline requires a subsequent 100% gain to return to the original investment value.
Can investment risk be eliminated?
No. Every investment involves some degree of risk. The goal is not to eliminate risk entirely but to manage it through appropriate diversification, asset allocation, and long-term planning.
Should investors react to every market decline?
Markets naturally experience periods of volatility. Making investment decisions based solely on short-term market movements may not support long-term financial goals. Many investors benefit from maintaining a disciplined investment strategy aligned with their objectives.
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Educational Disclaimer
This content is provided for educational purposes only and should not be considered investment advice. It does not take into account individual financial circumstances, investment objectives, or risk tolerance. Investors should consult with qualified financial professionals before making investment decisions.
The information contained in this blog does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Voyager Wealth Advisors and not necessarily those of Raymond James. Expressions of opinion are as of
this date and are subject to change without notice. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Past performance does not guarantee future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions.
