Investment Risk

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Every investment has some risk. Risk is defined as the probability that the yield is lower than expected.

On average, riskier investments have a higher yield, in the long run.

Short term US treasury bill are included among the lowest risk investments, since they are backed by the U.S. government. Stocks prices have a higher volatility than bond prices.

Loans to companies have a higher risk than loans to the government. Loans to individuals have a higher risk than loans to companies.

In the following chart we can track the evolution of a diversified investment in stocks, according to the Dow Jones index, and the evolution of a deposit in a commercial bank. investment risk

The blue line represents the investment in stocks. The volatility is higher. If you invested in the Dow Jones at the beginning of 2007 and sold your stocks at the beginning of 2009, you had had a significant negative performance.

The green line represents an investment in a commercial bank deposit. This investment has a lower risk and did not have a negative yield.

But on the long run, the yield of the stocks is higher than the yield of the bank deposit. This relation can be observed almost every time we consider a long time frame, for example, 10 years.

The investment risk can be decomposed in:

  • Credit risk: when the borrower doesn’t have the funds to repay. It happens when a business or individual has earnings that are lower than expected. For example, if a person takes a loan and then loses his job.

  • Inflation risk: when the inflation rates is higher than expected. If the nominal yield is 10% and the inflation rate is 15%, the real return rate is negative.

  • Currency risk: caused by the volatility of the exchange rates.

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