Investing is a fundamental aspect of finance. This not only allows us to maintain our purchasing power but also to increase our financial assets. When we invest, there is always a risk of loss, so it is necessary to know how to measure investment risk in order to be prepared in advance and achieve the expected profit. Read more about how to calculate it.

What is investment risk?

An investment risk or financial risk is the probability of losing money invested either because it does not provide the expected return or because the loss exceeds the initial contribution.

Knowing this, it must be taken into account that any investment entails a risk, however minimal it may be, and that the greater the investment, the greater the risk.

However, there are ways to prevent these risks and secure our investment. To do so, it is necessary to know what are the levels and types of risk in an investment.

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Risk levels

From an investor’s point of view, there are 3 levels of risk in an investment:

High risk

An investment with a high level of associated risk is one in which a large amount of capital and commitment is invested. This implies a higher level of expected return, but influenced by a high volatility factor.

Experienced investors who decide to make an investment at this level are trained and active throughout the process. One of the countermeasure strategies to minimize risks is to have a loss containment plan.

Medium risk

The level of risk assumed is lower than in the previous case, and as a consequence, the expected return is not as high as with higher levels of risk.

Here the levels of returns are considerable, but there is so much volatility. Some of the products are equity mutual funds.

Low risk

The low risk investment is one where the capital invested is very low, therefore the possibilities of loss are very low. As the risk we are willing to assume is lower and as a consequence, the expected return is not too high.

Within this level are fixed-term deposits or fixed-income mutual funds.

Types of risk

Now there are certain risks that are more predictable than others. Thus, we can classify them as follows:

1. Systemic or market risk

Systemic or market risk is the risk that directly affects the market regardless of the company in which it is invested, i.e., unpredictable risks related to the economy and other external factors.

An example of this type of risk are those derived from the pandemic, or could also be the 2008 crisis, which affected the world economy and many companies suffered partial or total losses.

Factors such as stock prices, interest rates, currency exchange rates or commodity prices can help you measure market risk, but you never know for sure what will happen.

The volatility of this type of risk is affected by the magnitude and speed of events.

2. Non-systemic risk

Also known as diversifiable risk, this type affects only a specific company, conditioned by its own factors that only affect the profitability of its stock or bond.

Some examples of this could be poor business results derived from a contract, lower than expected sales data, a new product from a competitor, fraud, poor management, lack of knowledge of a new investment, lack of attention, among others.

3. Liquidity risk

Liquidity risk is where a company has to sell its assets (goods or income) below market value. Another way of looking at it, however, may refer to the company’s ability to meet short-term obligations.

It can also be measured by liquidity ratios such as current assets and short-term debt.

There are only two classifications in liquidity risk, these are:

• Asset liquidity: when assets have the capacity to be traded or traded easily.

• Liquidity of funds: when one of the parties involved in the transaction does not have the funds to pay its obligations.

4. Credit risk

It may be known as default or counterparty risk, where the counterparty has little or no capacity to assume its obligations after it has been lent money.

Banking institutions are the ones that mostly run this type of risk, always carrying out studies that support the liquidity of the entity that requested the loan in order to minimize possible risks.

5. Legislative risk

This risk is influenced by the laws and regulations of the country, in this sense, these are the ones that dictate the level of risk in an investment.

Only the government can create, modify or eliminate certain laws that affect the operation in which capital has been invested.

One measure to reduce the chances of this is to invest in stable countries with established laws and not pending enactment; this way you will protect your capital and it will become a predictable risk.

6. Interest rate risk

As its name implies, it is subject to changes and variations of interest rates in the market, therefore, it is also called a systemic risk.

Although it can impact all types of assets, those most at risk are fixed income investments such as bonds or preferred stocks.

7. Inflation risk

One of the most unpredictable risks is the risk of inflation, especially when you are in a country where the rate is constantly rising.

This type of risk depends entirely on the economy; if inflation increases, the risk of it exceeding the profitability of your investment also increases.  In other words, it can impact the company’s purchasing power or return on investment.

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How to measure investment risk?

There are many alternatives to measure the risk of an investment, among these are:

Volatility

It is one of the most widely used indicators to assess the risk of an investment.

It indicates the frequency and magnitude with which asset prices vary. The more frequently the price changes, the greater the volatility of the investment.

To measure it, statistical parameters such as standard deviation are used, which will give you an overview of how an asset has performed in the past.

It is important to evaluate the volatility of equities as well as fixed income, in this way, you will be aware of the level of risk of the invested capital.

Profitability

This indicator measures the relationship between the return on an investment and the cost invested, showing how much of what was invested has been earned or whether it has only been recovered.

One way to calculate profitability is to analyze the value of the stocks you are going to invest in the market and see the outcome of your investment decisions.

Return on investment

It is also known as ROI. Through this indicator, the economic result of an investment is represented. Thus it is possible to know how much money you are gaining or losing with each investment made.

The formula for calculating the return on investment is the difference between the income and the amount invested.

Value at risk

Value-at-risk, or VaR for short, measures the risk of an investment through traditional statistical techniques, determining the probability of losses over a given period of time.

Most commonly, these probabilities range between 1 and 5%; if they exceed this number, it means that there is a high probability of losing an investment.

We can calculate the risk value in 3 ways:

• Historical VaR: with it, we measure returns generated in previous periods. It is not the most reliable way, since we are assuming that they will recur in the future, but by analyzing it we can see unseen opportunities.

• Parametric VaR: to calculate it, estimated returns are used and a normal distribution is assumed.

• VaR by Monte Carlo. It is calculated through a computer software that generates a large number of possible results according to the initial data entered by the user.

The risk traffic light for financial products

The CNMV has created a tool to facilitate the measurement of risk when investing and to improve the transparency of banks: the risk traffic light.

This measurement technique, created by the CNMV, can help us to assess the risk of financial products more easily by classifying them into six risk levels on a color scale, with green representing the least risky products and red the riskiest products.

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What should you take into account to minimize risks?

After knowing what investment risks are and how to calculate them, follow these tips to minimize the risks when investing your money.

• Knowing the investment assets: Sufficient knowledge of the market in which to invest will help to effectively measure investment risk and ensure a successful return.

• Anticipate unforeseen events: It is never possible to predict with certainty what is going to happen, however, being aware of what is happening and foreseeing certain situations will make an outcome within the expected feasible.

• Diversify investments: Doing so will ensure a balance between high and low risk, this is known as the golden rule among expert investors.

• Evaluate results: It is important to be aware of the evolution of the investment and evaluate the results, so you will be able to build a better strategy for future investments.

• Use risk management tools: You can take out insurance or apply protection policies such as a privacy notice to ensure the security of your project.

Knowing how to measure investment risk is important to consolidate projects or grow our assets, this becomes the starting point to make the right decisions about our money.

If you need help with your finances, go to our website TAS Consultancy or solve your doubts by writing to tasconsultoria@tas-sl.es, you can also call +34 93 737 75 25 and talk to one of our commercial advisors.