What Are Risk Assets?
The fact that most assets in the market carry risk can be a bit scary—but understanding risk assets will help to turn those dangers into steady returns.
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Can you live a truly risk-free life?
And even if you could, would you?
Just think about it. That would mean never going outside. Never doing anything remotely dangerous like crossing a street or petting a dog. Never experiencing the joy of doing something exciting, or achieving something difficult. 🤓
The stock market mimics life when it comes to risk and reward. It is also impossible to invest without risk, and great—yet calculated—risks often carry immense rewards. Since nearly all financial assets are risk assets, you can rest assured that many of them have the potential to bring great returns.
However, you first need to get to know them—while risks can be good, reckless risks tend to be incredibly dangerous. Nobody would want to repeat the Darien scheme for example—an investment so bad that it bankrupted a nation and made it lose its sovereignty.
So, let’s jump into risk assets in more detail: what they are, how they function, and importantly, how they can be properly managed.
Sound good? Let’s go! 👇
- What Are Risk Assets?
- The Definition of Risk
- The Impact of Risk Assets on a Portfolio
- What is a Risk-Free Asset?
- The Link Between Risk and Interest Rates
- Are Cryptocurrencies Risk Assets?
- Conclusion
- Get Started with a Stock Broker
What Are Risk Assets? 🤔
Risk assets represent a very broad category in finance—so much so that, by definition, pretty much everything is a risk asset. Stocks, commodities, currencies all fall under the definition. Debating between stocks and real estate and hoping one of them is riskless? You are not in luck, both are risky.
This goes so far that even most bonds aren’t considered risk-free assets. There are exceptions to this rule, but most corporate bonds and even some government bonds are generally considered to carry risk. Just think of Honduras bonds defaulting in 2022.
Risk assets have a different—yet very similar—definition in the context of banking. They represent any asset held by a bank—or other financial institution—whose value may fluctuate over time due to various factors.
So, at this point, two things are abundantly clear—pretty much anything you trade on the stock market will be a risk asset of some kind, and risk is an integral part of any risk asset. So, what is risk exactly?
The Definition of Risk 📚
In its essence, risk represents the chance that the actual outcome of an investment will differ from what the investor expects at the time of a transaction. Risk is usually determined by analyzing the historical performance of an asset and it tends to be closely related to the level of volatility.
Risk Fundamentals 📖
You might invest in a fledgling company with a promising business model expecting it to grow over the years—only for it to go bankrupt. Even startups that received huge financial backing from well-established names—like in the case of PayPal-backed LendUp—are prone to this. Alternatively, you might attempt to short a failing firm only for its stock to become a target of a major short squeeze.
The chance of a promising startup to fail, or a short to become a losing bet is represented through risk. There are numerous ways to figure out how risky an investment is—one of the most common ones being looking at its standard deviation.
However, the volatility of a stock is far from the only element affecting its level of risk, as there are several distinct kinds of risk. These include changes in a firm’s leadership, shifting values of currencies certain assets are traded in, geopolitical consideration, and proliferation of new technologies—like the impact of the internet on various brick and mortar retailers.
Alongside volatility, risk is closely associated with the idea of rewards. Generally speaking, the riskier an investment is, the higher its potential returns are—while large and well-established blue-chip companies like Coca-Cola certainly still have room to grow, it is highly unlikely you’ll see stellar returns going into hundreds of percents. 🔵
Risk comes in two main broad categories—systematic and unsystematic. Systematic risks represent factors that can affect an entire economic market, or—at the very least—a large portion of a market. Unsystematic risk has a bearing only on a particular industry or company.
Another important trait of systematic risk is that it can’t easily be mitigated by portfolio diversification—investing in broad index funds and choosing individual stocks from diverse fields can only take you so far.
Types of Systematic Risk 🗃
Country risk represents the risk that a country will not be able to fulfill its obligations. This is a reason why not all government-issued bonds are considered riskless, even if they’re labeled as low risk. Country risk is most often found in emerging markets but can affect nations in generally well-established economic zones—just think of the Greek economic crisis which is only ending in 2022 with the country’s plans to pay back the last of the bailout loans early.
Somewhat intuitively connected to country risk is political risk. This represents the risk stemming from volatile political situations affecting countries, regions, or even the entire globe. A stark and dark example of this type of risk came in early 2022 with Russia’s invasion of Ukraine which quickly sent shockwaves throughout the world’s financial markets.
Investing in markets that deal with currencies other than that of your own country carries foreign-exchange risk. Put simply, when investing in Japanese stocks from the U.S., you can still lose money even if the value of your shares goes up if the Yen depreciates enough.
Interest risk—unusually relevant in 2022 with the debate surrounding the Fed’s planned interest rate hikes—is another reason why fixed-income instruments aren’t universally regarded as risk-free. It primarily affects bonds and represents the possibility of their value falling if interest rates rise, or rising if interest rates are lowered. 📉
Liquidity risk is fairly self-explanatory. It represents the danger that an investor won’t be able to sell their assets for cash if the need arises. This type of systematic risk is often connected to the volume of the stocks in question, but can also be compounded by other types of risk. For example, political risk can play a factor if—for example—a country temporarily blocks the trading of a certain asset at a pivotal time.
Types of Unsystematic Risk 📂
Business risk refers to the dangers of the poor performance by a company you’ve invested in. This type of risk encompasses numerous hurdles a company might face ranging from a firm being knocked out of business by competitors to potential troubles with paying salaries, production, and maintaining office space.
While credit risk can refer to government-issued bonds, it is a far bigger factor for corporate fixed-income instruments—which can even sometimes be plain old junk bonds. This is the risk that a corporation or a government—again, think about the Greek government-debt crisis—will not be able to pay back its dues. The primary method of avoiding this type of risk is to perform proper research when buying bonds and to make sure the emotion of greed isn’t a primary factor in buying the aforementioned junk bonds in the first place.
Counterparty risk is carried by most financial instruments—options, stocks, derivatives, and bonds. It mostly affects the over-the-counter market and represents the probability that one of the parties in a transaction won’t fulfill its obligations.
The Impact of Risk Assets on a Portfolio 📊
Since nearly all assets found in the stock market are considered risk assets, you will inevitably have risk assets in your portfolio. The most obvious impact they will have is volatility—meaning an influence on the likelihood of you losing, or gaining, some capital.
While this might appear scary at first glance, you should remember that there is a chance of losing money no matter what you do in the stock market—and that you can manage this risk by thoroughly analyzing your stock investments beforehand with both technical and fundamental analysis.
Furthermore, when it comes to the stock market, the rule of thumb is that the higher the risk, the higher the potential reward. Amazon was far from a safe bet in 1997, but those who invested just $1,000 in the company back then (and held the stock) would be pretty much set for life just 20 years later.
On the other hand, this doesn’t mean that every small company or every penny stock is a growth investment. As the potential gains can be quite high exponentially in such investments, so are there significant dangers in terms of the associated risks.
The Balance Between Risk and Reward ⚖
The close connection between risk and reward—and risk assets and your portfolio—means that you will have to strike a balance between the two. While the first step in achieving this is accepting that risk is inevitable, the most important one is learning how to find assets that carry the least amount of risk and the highest possible reward.
This step might appear like a bit of a no-brainer at first glance. Since everybody knows that high-tech companies are really in now, you might consider finding a relatively new firm in that industry and investing. But, this line of thinking was partially responsible for the dot-com bubble.
Furthermore, tech companies might be at the center of a new superbubble. That’s why it’s clear that finding quality stocks at a discount is indeed both an art and a science. Fortunately though, knowing is half the battle, and—for example—being aware of the existence of business risk enables you to see warning signs of a bad investment early. 🕵️♂️
That still doesn’t mean that things can’t be confusing. While some see a new crash forming around big tech, others think that these giants have yet to fully shine. Weeding through the intricacies of spotting dangers and opportunities can be a daunting challenge. But, practice makes perfect, and knowledge is power—while they may not be the first to come to mind, adding the tried-and-tested techniques of the Dow theory, and the mosaic theory’s holistic approach can be invaluable for assets in a struggle.
The balance between risk and reward also has to be your personal decision. Not every investor has the same appetites and not every investor has the same risk tolerance. While this can often depend on your temperament, your age is also an important factor. The rule of thumb is that younger investors—with time on their side and fewer savings to lose—can afford riskier deals. ⏳
On the other hand, investors nearing retirement should generally play it safe. It would be a shame to lose all your hard-earned money a year before moving to Florida and going on that dream cruise by investing in some shady THC-related penny stocks.
Some would even argue that having too much money invested as you’re getting older is an unexpected way to skew your portfolio towards undesired risk.
How to Manage (and Minimize) Risk 👷♂️
Getting to know various tools of stock analysis can truly help you figure out which risk assets to pick—and finding reliable analysis software can make the process a lot easier. Yet there are still some methods of minimizing risk that will work in a vast majority of cases. One of them is diversification.
Diversification is often mentioned as a way of minimizing risk for a very good reason—it works fairly reliably. There are many ways you can achieve it for your portfolio. You could invest in mutual funds for example. You could also pick individual stocks from a variety of industries to ensure that a crisis in any of them won’t put too much of a dent in your investments. 📜
A very common way of having a robustly diversified portfolio is combining different types of assets—by mixing stocks, high-quality bonds, and gold you can all but ensure you’ll do reasonably well under most circumstances, and won’t become penniless in the worst of cases.
An important thing to remember though is that diversification for the sake of diversification isn’t enough. Holding shares of 100 different solar energy companies isn’t diversification. It wouldn’t do anything to protect you from a hypothetical solar crash—a supernova if you will.
Similarly, hedging against a volatile market by filling your portfolio with various high-quality bonds is sure only to stifle your returns—or it might even cause you to lose money due to seemingly endless record inflation.
When you’ve nicely diversified your portfolio, you should remember not to give in to the temptation to micromanage. Indeed, trying to day trade your way to riches is often a path leading to bankruptcy rather than the vault of Scrooge McDuck. 🚧
This doesn’t mean you should be complacent, and it is wise to be on the lookout for good opportunities to buy and sell—and dangers to hedge against. But there isn’t anything wrong with just letting your investments grow over many years—it will even grant you more favorable capital gains taxes.
This is especially true if you are young and just starting out. No matter how bleak the current situation may look, a properly diversified portfolio should be able to recover from most crises and make you a lot of money throughout your life. The stock market has spent most of the last 100 years on an overall upward trajectory, and there is little reason to believe this trend will end.
What is a Risk-Free Asset? 👨🏫
A risk-free—or riskless—asset is, as the name suggests, a financial vehicle that carries little to no risk. This means that these assets have a precisely known return that will not change over time. These financial vehicles play an important role in the world’s economic ecosystem.
Low-risk assets often serve as collateral—a guarantee that all parties will honor an agreement—in securities lending deals. Furthermore, they help institutions like banks meet regulatory standards as they provide the liquidity necessary for them to operate.
However, we have spent a lot of time explaining that pretty much all assets are risk-assets, so what exactly is considered a risk-free asset?
Example of a Risk-Free Asset 📙
While not all government bonds are considered riskless, U.S. Treasury bonds are. This is mostly due to the combined factors of the U.S. continuous financial stability, and the overall strength of its economy. This makes these fixed-income investments a benchmark for investing.
The basic idea is that if a potential investment promises worse returns than these bonds, it is a bad investment. Why would you take on additional risk for no extra reward? Additionally, these instruments issued by the U.S. Treasury can help you find and compare other riskless assets.
For example, bonds of other countries and institutions—like the Bank of England—as well as certain extremely stable blue-chip stocks might also be considered risk-free, or at least ‘low-risk’ assets.
What Does it Mean to Have a Risk-Free Asset? 🧐
The effects of risk-free assets are manifold. They help you determine whether certain riskier investments are worth the additional danger. Also, holding these assets lowers the overall risk of your portfolio and helps you hedge against catastrophic losses if push comes to shove.
Remember though that while inflation will eat away at your cash faster than your bond investments, it can still outpace the returns and cause you to lose money if you hold too much in fixed-income instruments. Furthermore, bonds are pretty much guaranteed to stifle the growth of your savings—especially in a bullish market.
Lastly, bonds have their own risk-inducing arch-nemesis in the form of changing interest rates.
The Link Between Risk and Interest Rates 🔗
If the heightened inflation which started in late 2021 hasn’t caused enough headaches, the Fed’s plans to combat it by raising interest rates added to existing worries. Considering how closely the increase in interest rates aligned with the dot-com bubble bursting at the turn of the millennium, the wary looks leveled at the decision aren’t surprising.
While the link between the crash and interest rates appears to be more of a case of correlation than causation, the Fed raising the Federal funds rate tends to have a depressing effect on the market as a whole. Whenever the rates go up, the market slows down—and vice-versa. 📈
This happens largely because investments and growth largely depend on two things—borrowing money, and the amount of disposable income. Higher interest rates make borrowing more expensive—and discourage it—and saving money more lucrative—and encourage it.
Considering that the world has gone through several upheavals of various kinds since 2019—the Hong Kong protests, covid-19, heightened inflation, and the ongoing crisis in Ukraine—and that many economists see trouble on the horizon, it is no wonder that the Fed is indecisive about raising the Federal funds rate. There appears to be pushback within the institution against aggressive intervention in the hopes that inflation will level off on its own.
Interest rates have a close connection to risk—and riskless—assets. A slowed-down economy means that struggling stocks are in danger of dropping further, and soaring ones might have their wings unexpectedly clipped. 💸
The Federal funds rate also has a particularly pronounced effect on fixed-income securities—thus lending additional credence to the belief that there are no real risk-free assets.
This relationship between the two is inverse—higher interest rates lead to bond prices falling and vice-versa. Since bond investors are not very different than anybody else—they want the best deal possible—they are always on the lookout for better returns. As soon as new bonds are issued following an interest rate hike, the return rate of old bonds becomes less appealing, thus lowering their prices.
Are Cryptocurrencies Risk Assets? 🪙
In short, cryptocurrencies definitely are risk assets. They are highly volatile, and there is no guarantee where their value will go. This reality is perfectly highlighted by the history of Bitcoin prices which is a near-insane roller coaster. Just a decade after its inception, the digital asset was worth nearly $20,000 and then fell sharply, before soaring to over $60,000—and falling down to $35,000 in late January 2022.
The cryptocurrencies’ link to risk was further established in 2021 when the Fed singled them out as a major indication of investors’ increased risk-taking appetites. While the prices of Ethereum—the second largest cryptocurrency by market cap—have seen somewhat less dramatic changes over the years, its history is still full enough of peaks and valleys that nobody could mistake them for the relatively riskless U.S. Treasury bonds.
This comparatively staggering volatility still doesn’t mean that you can’t include crypto in your portfolio without driving risk through the roof. The usual methods of good planning, diversification, and patience can still go a long way when mitigating risks. You could also further hedge yourself against too much danger of losses by learning how a Bitcoin ETF works.
Conclusion 🏁
While risk assets are a bit of an alarming name to the uninitiated, they are both unavoidable and beneficial to most investors. The main thing when interacting with these stocks, commodities, derivatives, and currencies is to maintain a cool head and perform due diligence when researching.
Furthermore, understanding risk-free assets and their unique interaction with interest rates—and how you can mix them in with your risk assets—is almost a surefire way of coming out of the stock market with more wealth than you went into it.
Defining Risk in Assets: FAQs
-
Is a Bitcoin Investment Considered ‘Risk-free’?
An investment in Bitcoin is not considered risk-free. In fact, a BTC investment is a relatively high-risk investment due to how common sharp changes in its value are. On the other hand, as is often the case with high-risk assets, BTC is potentially a very high reward investment.
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What Asset is Most at Risk?
Generally speaking, equities (especially tech stocks) are considered higher-risk assets as they involve buying shares of private companies. It can also be argued that cryptocurrencies are very high-risk assets due to their common and dramatic price changes.
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Which Asset Has the Highest Return?
Traditionally, stocks have been considered the asset with the highest rate of return. More recently, cryptocurrencies have emerged as assets with the potential for incredibly high returns. You should keep in mind that in most cases the higher the returns however, the higher the risk.
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What Type of Investment Has the Lowest Risk?
US Treasury bonds are assets with very low risk. In fact, they are often considered risk-free, or riskless—though extremely low risk would probably be a more accurate description. That being said, bonds are uniquely susceptible to interest risk.
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Is Cash a Risk Asset?
Cash is a low-risk asset but it also has an extremely low potential rate of return. In fact, cash can often have negative return rates due to the effects of inflation. Additionally, cash can carry varying degrees of risk depending on its issuer.
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