Updated March 2025
INVESTMENT RISKS
Abstract: Investment risk is typically presented to investors in terms of the probable standard deviation of their asset mix. However, standard deviations are simply a measure of volatility in portfolios. Investors are more likely to experience and understand risk in their portfolios in terms of price declines in worst cases and how long those declines last and how permanent those declines might be. This article examines nine general categories of investment risk including price declines, default risk, bank failures, currency risk, macroeconomic risks, moral risk, liquidity risk, capital controls, catastrophe risk and cyber risk. Risk can arise instantly without warning from multiple factors. Wall Street almost never sees problems ahead and is always optimistic to retail investors.
ABOUT INVESTMENT RISKS
All investments entail risk, whether bought and sold on public exchanges or privately and whether or not it is government or private debt or equity. It is imperative investors understand there is always some risk of a decline in price in any investment or a total loss. This article summarizes nine categories of risk and is intended to provide a general summary of the risks investors face. Additional investment risks not listed in this overview exist. Another article on our website, "Risk and Return", examines the statistics of portfolio risk and "Financial Superstructures" examines non-quantifiable risks to investment markets and portfolios.
PRICE DECLINES: This probably is the most common way investors think of risk, the risk of a decline in the value of their investments. Countless factors can lead to declines in the value of stocks, bonds, mutual funds, real estate, gold, commodities or other investments. These include but are not limited to earnings disappointments, analyst downgrades, changing industry regulations, declining industry or company competitiveness, credit crises, terrorist attacks, natural disasters, manias, panics and crashes, corporate fraud, exchange rate shifts, market manipulation by major players, cash price manipulations caused by futures contracts, flash crashes from high frequency trading, and "normal" but large long-term variations in means and variances for asset classes for up to 40 years. If something is traded, its price will vary and may decline for an extended period longer than an investor may be willing to wait.
DEFAULT RISK: When an individual bond defaults or is in deliquency the bond has little or no value. Often, investors will have to wait for an indefinite period of time and receive less than full value when a refund is finally made if it is made. Numerous factors can generate bond defaults including excessive leverage, corporate fraud, failing financial conditions for issuers, economic recessions, and declining revenues for debt service. And, as the collapse of Enron and WorldCom and the 2008 credit crisis dramatically illustrated, ratings companies like Moody's and S&P may not provide investors with accurate advance assessments of credit quality. Even bond insurance companies can fail. Defaults by countries on sovereign Treasury debt have been common throughout financial history. Pleasse see the book review on our website, "This Time is Different", by Reinhart and Rogoff.
COUNTERPARTY RISKS: Counterparties in a variety of securities transactions, including entities involved in the creation and redemption of ETF shares, bond issuers, mortgage issuers, and derivatives issuers, can fail to honor their contractual promises resulting in losses to investors. Clearing houses which move money between buyers and sellers can also fail.
BANK FAILURES: It is not uncommon for banks and insurance companies to fail, even old and established ones. In the 1995, Barings Bank, a venerable 233-year-old English firm, was destroyed by one rogue derivatives trader.
CURRENCY RISK: All paper money, often called "fiat" currency because countries declare its value by dictate, has ultimately declined to zero value. There are no exceptions. The US dollar for example has lost about 98% of its purchasing power since the Federal Reserve was created in 1913. The Fed's mandate according to Fed chairman Jerome Powell as of 2019 is to maintain stable prices. Mission not accomplished. Equities and bonds are often called paper assets to distinguish them from real estate, commodities, and precious metals, which are real assets existing in the real world though there price is based on fiat currency. Thus, US investors in equities and bonds are essentially buying paper promises in the US dollar, a fiat currency and itself a paper promise. A rapid devaluation in the U.S. dollar could cause a rapid decline in the value of equities and bonds traded on U.S. exchanges. From March 2020 through January 2021 the US dollar exchange rate with other major currencies has declined a large 10.8%.
MACROECONOMIC RISK: Depressions, inflation, and hyperinflation can lower or destroy asset values for a decade or more. History clearly shows us that they aren't frequent but probably occur more often than most investors expect. In the 20th century the United States was fortunate to have unquestioned world dominance in industrial production, GDP output, military strength and other important measures yet it suffered from one major depression and one serious bout of inflation and both lasted more than a decade. Timing these events was, of course, impossible. In addition, central banks and governments often resort to inflationary policies and excessive fiat currency issuance through borrowing and printing and digital money creation. These macroeconomic maneuvers may support or increase the nominal value of investment assets short term but lead to inflation, mispricing and asset bubbles and crashes later on.
MORAL RISK: For want of a better term moral risk applies to countless legal and illegal schemes by which financial companies, corporations, analysts, registered investment firms, regulators and others misrepresent material issues, play accounting games, engage in insider trading, or manipulate markets. Anyone who has followed financial news over the last decade knows that these events are pretty much regular occurrences in financial markets today and anyone who has studied the history of financial markets knows that this has always been the case. A few recent examples are Enron, Worldcom, Countrywide, and the Goldman scheme where a hedge fund manager directed Goldman to assemble a portfolio of mortgages in 2007 which had a high probability of failing and Goldman then sold them to its clients. Ninety-nine percent of the mortgages failed yet due to legal technicalities neither Goldman nor the manager suffered any financial consequences. An article elswhere on our website, "Financial Superstructures" examines the many entities involved directly or indirectly in financial markets, the interests of participants within them, and how they influence influence investment risks and returns.
The prospect of big money, typically in the tens of millions or greater today, often draws participants into financial misbehavior. Typically the consequences for doing so consist of a fine which is often paid by proceeds from the shareholders in the corporation, not the executives and money managers who perpetrate these schemes. In fact, corporations often buy insurance to protect executives from lawsuits. The fines paid usually constitute a small percentage of the profits made from the scheme and it is very rare for perpetrators to face jail or prison time. Fines are typically paid without admitting or denying guilt. Many observers believe that these fines are simply rationalized as a cost of doing business.
LIQUIDITY RISK: Far less frequently considered by investors and infrequently mentioned in the financial press is illiquidity. Illiquidity occurs when securities which could normally be bought and sold on exchanges or in various markets cannot be bought or sold for some period of time. The market has failed. The financial industry and financial media don't like to mention illiquidity since the idea of orderly and constantly liquid markets is the backbone of modern capitalism. Sellers and buyers want to assume that they can buy or sell a security if and when they wish to. That is not always so.
All markets for all securities have been subject to trading halts, circuit breakers, and at times been frozen or abandoned by the firms which run exchanges or markets. Examples include the NYSE, shut down for 5 months in WWI and for several days after 911, the "flash crash" of May 6, 2010, and the total abandonment of the auction rate market in February 2008 by Goldman, Blackrock, Nuveen and other auction brokers. The New York Times (3-28-2012), "Stock Market Flaws Not So Rare, Data Shows", reported that trading had been blocked at least 110 times across the nation's 13 stock exchanges in 2011 and this number had been rising every year since 2007. Bond markets can be closed but the major risk is that bondholders simply cannot obtain bids and thus their bonds cannot be sold.
CAPITAL CONTROLS: Economic history clearly demonstrates that governments and financial regulators in the midst of a financial crisis will do pretty much what they want to with private investment assets, businesses, and markets. Often called "capital controls", these include suspending or setting maximum withdrawals from banks or money markets, curtailing or suspending international bank transfers and foreign exchange transactions, blocking short selling in equity markets, criminalizing the purchase, ownership, or exportation of precious metals, and fixing a nation's exchange rate rather than letting free markets do so. In September 2008 the SEC halted short selling in financial stocks "to protect investors and markets". A more accurate analysis would be that the SEC halted short selling in order to prop up equity positions held by major US investment banks which would have become insolvent had the markets been allowed to operate as they are supposed to and engage in price discovery.
In 1933, FDR forbade private ownership of gold and effectively devalued the US dollar against gold. Holders of gold were paid $25/ounce and once all gold in private hands had been collected gold was immediately revalued to $35/ounce, effectively shortchanging what the former owners of the gold received by about 40% from what the pre-1933 market offered. In 1967, the US Congress voted to use all Social Security contributions for current government expenses, putting I.O.U's in place to fund future obligations for Social Security recipients. Repayment of these I.O.U.'s is dependent upon future US government borrowing, not incurred until the Social Security distributions are needed. The estimated unfunded liabilities of the Social Security "Trust Fund" are over $34.3 trillion as of 2018 or about 2x+ 2020 GDP and it's climbing fast in 2021 as the US government continues to call rising debt "stimulus". Since 2010, Social Security has been cash flow negative with current contributions from current workers failing to keep up with current distributions to Social Security recipients. A major cause of this shortfall is the aging of baby boomers born between 1946 and 1964 and their numbers are growing rapidly as of 2019 And, there is no Social Security "Trust Fund" though that term is used frequently. The Trust fund is just a reassuring name for non-negotiable I.O.U's to be funded by presumed future US Treasury borrowing.
In 2001 the Argentinian government defaulted on its debt, the largest sovereign default in history, and during the 2008 financial crisis its borrowing costs rose so high that the socialist government nationalized a substantial portion of private pensions to help pay its debts, essentially stealing what private investors had put aside. As of 2011, at least one US think tank and several Congresspeople have discussed nationalizing US 401-k's in exchange for GRA's, guaranteed retirement accounts, where the US government promises to pay an inflation-adjusted subsidy administered by Social Security. In August 2013 the Polish government nationalized half of their citizen's private retirement plans. While unlikely, it could happen to US investors.
CATASTROPHE RISK: Natural or man-made catastrophes can rock financial markets and securities prices. Recent examples include 911 and Hurricane Katrina. Investment companies can use "exigent circumstances" or "force majeure" as a defense against claims of loss by investors.
CYBERRISK: This was probably the least talked about risk in publically traded securities in 2010 but as of 2021 cyberrisk was frequently discussed in the financial press and concerns are growing. In February 2011, an article appeared reporting that hackers had invaded the Nasdaq trading system (Wall Street Journal, 2-5-11). Reuters (10-20-11) reported that new details showed the cyber-attack was more serious than previously thought. It seems hackers installed malicious software that allowed them to spy on confidential information on exchanges and documents circulated amongst boards of directors. Nasdaq also said that they were not clear how long Nasdaq's system was breached before the attack was discovered and that they are spending about one billion dollars a year on information security.
Hackers also launched six attacks against the European Union's carbon trading systems and stole 50 million pounds (Financial Times, 2-15-2011), and Chinese hackers mounted multiple cyber-attacks against leading oil and gas companies (Financial Times, 2-12-11). Stewart Baker, former assistant secretary of Homeland Security, said to the Financial Times that the intrusion on the oil and gas companies, "could well be the Chinese government, but I can't say the government would even have to be aware of it." Hackers used previously known software flaws and did not go to great lengths to cover their tracks researchers said. The US government accused the Chinese of being the world's "most active and persistent" perpetrators of economic spying and also said Russian intelligence agents are conducting extensive spying to collect US economic data and technology (WSJ, 11-3-11). The article quotes a senior intelligence official, "Cyber has become the great game-changer."
On 6-18-11 the Financial Times published an article listing the victims of hackers in the prior two weeks; these included the IMF, the CIA, Sony, the Turkish government, Citibank, and the US Senate. It stated, "...networked computer systems have never been more vulnerable". Bloomberg Businessweek (7-25-11) examined the worlds of intellectual property theft (through computers), botnet collections with covert outside control across hundreds of thousands of interconnected computers, zero-day "exploits" using existing software from Microsoft and others that is undetectable until it strikes, and high end firms marketing and selling expensive "digital weaponry" to the US government and military. On 8-4-11, the Financial Times cited McAfee, a US computer security firm, whose research found that cyberespionage operations had penetrated 72 large organizations through just one server in one attack, stealing everything from military secrets to industrial designs and intellectual property from the UN, US and other governments and 13 defense contractors. On 10-21-13 the Financial Times reported that SIFMA, a financial industry regulator representing some of the biggest banks on Wall Street, says it will push for closer cooperation with the US government following a simulated cyber attack that mimicked a closure of the US stock market. A report released in 2013 showed that more than half the world's securities exchanges had fought off cyber-attacks during the prior 12 months and another study found the number of companies reporting cyber-attacks aimed at stealing commercial secrets doubled in 2012 and 2013 compared to the previous financial year. Cyberespionage is a rapidly growing industry as of 2021 and the problem has is becoming much worse as of early 2021. Although investors are quick to forget unpleasant market events and the financial press doesn't refer to past debacles in financial markets, the outline of events above makes it clear that dishonesty, manipulation and fraud in financial markets are common, not uncommon, events. Any investor in publically traded markets who reads market history will find constant examples of this.
Based on financial and economic history and on the history of securities prices it is correct and accurate to state that the future is unpredictable, that investors may not know critical information until it is too late, that losses may occur in any investment asset class for any number of reasons, that the financial industry may not warn of developing risks, and that any investment may lead to the partial or complete loss of principal. IN SIMPLE TERMS, ANY INVESTMENT IN ANY SECURITY TRADED ON PUBLIC EXCHANGES MAY LOSE AN INVESTOR SOME OR ALL OF THEIR MONEY. IF YOU DO NOT WANT TO TAKE THIS RISK IN THE PUBLIC MARKETS YOU SHOULD NOT INVEST IN PUBLIC MARKETS. Each investor must be responsible for soberly and honestly appraising their willingness to take risks and potentially lose money. Of course, historical market data show there are potential returns for doing so.