Managing risk

What is risk?

In finance, risk is the potential that your chosen investment may fail to deliver the outcome you anticipate. This could result in lower returns than expected, but it could also mean losing all or part of your original investment, or in certain cases even more than this.

Market risk

Market risk is the ever-present potential for your portfolio to suffer losses due to fluctuations in the market’s risk factors. These are the components of a market that are often volatile and exert significant pressure on prices. Generally, the key market risk factors are:

  • Stock prices
  • Interest rates
  • Foreign exchange rates
  • Commodity prices

These four are the key factors as they exert the most pressure on the market. Another name for market risk is volatility.

Liquidity risk

Liquidity risk stems from the possibility that you will be unable to trade an asset without affecting that asset's price.

It is generally more of an issue in emerging or low-volume markets, and comes in two types:

Asset liquidity

This refers to an asset’s ability to be traded – if nobody wants to buy, for example, then a stockholder won’t be able to sell their asset, or they may have to sell at a less favourable price.

If there are a lot of active traders, this will usually create good liquidity as there are likely to be a mix of buyers and sellers who are willing to trade. The more liquid a market is, the easier it is to buy or sell that asset.

Asset liquidity is an important part of market risk.

Funding liquidity

This refers to the ability to meet your financial obligations as soon as you need to. Funding liquidity risk, then, is the possibility that over a certain time period, one party (for example the bank) won’t have the funds available to settle its obligations straight away.

Funding liquidity most often applies in markets where assets are traded in high-volume blocks, or where the assets themselves are of a particularly high value (such as property or housing markets).