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In asset management, it is important to understand not only “how much return can be expected,” but also “what kinds of risks are involved.”
In investing, “risk” does not simply mean “danger” or “losing money.” It is used to describe the “uncertainty” of how much future returns or asset values may fluctuate as stock prices, interest rates, exchange rates, corporate creditworthiness, and other factors change.
Even when investing the same ¥100,000, deposits, government bonds, stocks, investment trusts, FX, and CFDs differ in the causes of potential losses and the magnitude of their price movements.
This article organizes the basics for learning about asset management, including what risk means in investing, what representative types of risk exist, and which financial products are closely associated with each type of risk.
Note:
This article is a personal study note for learning about asset management and investment risk. It does not recommend investing in any particular financial product, stock, currency, securities company, or other investment. When actually investing, make your own decisions after checking the latest product details, prices, interest rates, fees, taxes, risks, and other relevant information.
- What Is “Risk” in Investing?
- High Risk Does Not Mean You Will Always Lose Money
- The Relationship Between Risk and Return
- Price Fluctuation Risk
- Credit Risk
- Interest Rate Risk
- Foreign Exchange Risk
- Liquidity Risk
- Leverage Risk
- Forced Liquidation Risk
- Inflation Risk
- Reinvestment Risk
- Consider Opportunity Loss as Well
- Deposits Also Have Risks
- Government Bonds Also Have Risks
- Main Risks of Stocks
- Main Risks of Investment Trusts and ETFs
- Main Risks of FX
- Main Risks of CFDs
- Different Financial Products Have Different Types of Risk
- The Level of Risk Can Vary Even Within the Same Type of Product
- It Is Difficult to Eliminate Risk Completely
- Reducing Risk Through Diversification
- Diversifying Investment Timing
- Separate Living Expenses from Investment Funds
- Consider Not Only “How Much Can I Make?” but Also “How Much Could I Lose?”
- Consider How Much Risk You Can Tolerate
- Summary
- References
What Is “Risk” in Investing?
In ordinary conversation, the word “risk” may be used to mean “danger” or “the possibility of suffering a loss.”
In investing and asset management, however, risk is also used to describe the “uncertainty” of not knowing how much future returns or prices may fluctuate.
For example, if you purchase ¥100,000 worth of stock, it may be worth ¥120,000 one year later, or it may be worth ¥80,000.
This range of possible future outcomes is the basic concept of risk in investing.
Example:
Financial Product A is expected to remain at approximately ¥100,000 one year later.
Financial Product B may fluctuate between approximately ¥70,000 and ¥130,000 one year later.
In this case, Financial Product B is generally considered to have “higher risk” because its price and return fluctuations are larger.
High Risk Does Not Mean You Will Always Lose Money
Just because a financial product has high risk does not mean that a loss will always occur.
While its price may fall significantly, it may also rise significantly.
Conversely, financial products with small price movements tend to be less likely to produce large losses, but they also tend to make large profits more difficult to obtain.
Therefore, asset management is not simply a matter of saying, “You should choose only low-risk products” or “You should avoid high-risk products.”
It is necessary to consider how much return you want and how much price fluctuation or loss you can tolerate in order to obtain that return.
The Relationship Between Risk and Return
In investing, financial products that offer the potential for higher returns generally tend to have larger fluctuations in prices and returns.
This relationship is called the “relationship between risk and return.”
| Example of Financial Product | Expected Return | Price Fluctuation |
|---|---|---|
| Ordinary deposits | Small | Almost none |
| Government bonds | Relatively small | Varies depending on the product |
| Stocks | May be relatively large | May be large |
| FX | May become large | May be large |
| CFDs | May become large | May be large |
However, high risk does not mean that high profits will always be obtained.
It means that while there is a “possibility” of obtaining high profits, there is also a possibility of suffering large losses.
Price Fluctuation Risk
Price fluctuation risk is the risk of suffering a loss because the market price of a financial product you purchased changes.
It exists in many financial products whose prices are determined in the market, including stocks, ETFs, REITs, and bonds.
Example:
If the market value of stock purchased for ¥100,000 falls to ¥80,000, an unrealized loss of ¥20,000 occurs.
If the stock is sold in that state, the loss becomes realized.
Even if the price falls, the loss may not become realized unless the asset is sold, but there is no guarantee that the price will later recover.
Credit Risk
Credit risk is the risk that a company, country, or other entity that has issued stocks, bonds, or other securities may become unable to make scheduled payments.
In the case of bonds, if the issuer’s financial condition deteriorates, interest payments or repayment of principal may not be made.
In the case of stocks, if a company goes bankrupt, the value of its shares may decline significantly or become almost worthless.
| Product | Example of Credit Risk |
|---|---|
| Government bonds | The issuing country becomes unable to repay principal or pay interest |
| Corporate bonds | The issuing company becomes unable to pay interest or repay principal |
| Stocks | Deterioration in company management or bankruptcy |
Interest Rate Risk
Interest rate risk is the risk that changes in market interest rates will affect the prices and profitability of bonds and other financial products.
In particular, with fixed-rate bonds, market interest rates and bond prices tend to move in opposite directions.
In general, when market interest rates rise, the prices of already-issued fixed-rate bonds tend to fall, while when market interest rates decline, the prices of existing bonds tend to rise.
Example:
Suppose you hold a government bond with a fixed annual interest rate of 2%.
If the yield on newly issued government bonds subsequently rises to 4%, the existing government bond that pays only 2% annual interest becomes relatively less attractive.
As a result, its price may decline if it is sold on the market.
Conversely, if the yield on newly issued government bonds falls to 1%, an existing government bond paying 2% becomes relatively more valuable, and its market price may rise.
Foreign Exchange Risk
Foreign exchange risk is the risk that changes in the exchange rate between a foreign currency and the Japanese yen will cause the value of assets or profits converted into yen to fluctuate.
It is important when investing in foreign stocks, foreign bonds, investment trusts that invest in foreign assets, FX, and other products.
Example:
If you purchase $1,000 worth of assets when the exchange rate is ¥150 per dollar, the value in yen is ¥150,000.
Even if the price of the asset itself does not change, if the yen strengthens and the exchange rate becomes ¥130 per dollar, its value in yen becomes ¥130,000.
In this case, even though the dollar-denominated price has not changed, the value in yen decreases by ¥20,000.
Conversely, if the yen weakens, the value of the asset converted into yen may increase.
Liquidity Risk
Liquidity risk is the risk that when you want to sell a financial product, you may not be able to sell it immediately at your desired price.
This risk may be relatively small for actively traded large-cap stocks, but it can become an issue for stocks, bonds, and other products with low trading volumes.
If there are few buyers, it may be necessary to significantly lower the price in order to sell.
Leverage Risk
Leverage is a mechanism that allows a larger transaction to be conducted using a relatively small amount of your own capital.
In margin transactions such as FX and CFDs, it is possible to trade amounts larger than the margin deposited.
While leverage can improve capital efficiency, it also increases losses when prices move in an unfavorable direction.
Example:
If you use ¥100,000 of your own funds to purchase ¥100,000 worth of a product and its price falls by 10%, the loss is approximately ¥10,000.
On the other hand, if you use ¥100,000 of your own funds and leverage to trade ¥1,000,000 worth of a product, a 10% decline in the underlying asset may result in a loss of approximately ¥100,000.
The higher the leverage, the greater the impact even a small price movement can have on your own capital.
Forced Liquidation Risk
In FX, CFDs, and other margin transactions, if losses increase and the margin maintenance ratio or another measure falls below a certain level, a financial institution may forcibly close a position.
This mechanism is called forced liquidation.
Forced liquidation is designed to limit the expansion of losses to some extent, but if the market moves rapidly, the position may not be closed at the expected price.
In margin trading, it may not always be possible simply to “wait until the price recovers,” so managing the margin maintenance ratio and leverage is important.
Inflation Risk
Inflation risk is the risk that rising prices will reduce the real purchasing power of money.
Even if a bank deposit balance remains unchanged at ¥1,000,000, a significant increase in prices will reduce the amount of goods and services that ¥1,000,000 can purchase.
Example:
If a product that currently costs ¥100 rises to ¥120 in the future because of inflation, the number of units that can be purchased with the same ¥10,000 will decrease.
Therefore, even assets such as bank deposits, whose principal amount is unlikely to decrease numerically, may lose real value.
Reinvestment Risk
Reinvestment risk is the possibility that when a financial product reaches maturity or interest is received, the money cannot be reinvested under the same conditions.
For example, if a bond paying 3% annually reaches maturity when market interest rates have fallen to 1%, it may not be possible to reinvest the returned funds at the same annual rate of 3%.
This is a risk worth considering for products such as time deposits and bonds in which funds are returned after a certain period.
Consider Opportunity Loss as Well
Even if a financial product itself does not generate a loss, there may be cases where choosing a different product would have produced a larger profit.
This may be considered an opportunity loss.
Example:
Suppose that after purchasing a 10-year government bond with a fixed annual interest rate of 2%, market interest rates rise to 4%.
Even if you can receive the principal and predetermined interest by holding the bond until maturity, you can consider that you have missed the opportunity to invest at the higher 4% interest rate.
However, future interest rates and prices cannot be predicted accurately in advance.
Deposits Also Have Risks
Deposits are generally considered low-risk assets because their market value does not fluctuate significantly like stocks or FX.
However, deposits also face risks such as a decline in real value due to inflation and risks related to the creditworthiness of financial institutions.
In Japan, the deposit insurance system provides a mechanism for protecting depositors’ assets under certain conditions, but not all financial products or all amounts are protected unconditionally.
Government Bonds Also Have Risks
Government bonds are bonds issued by governments and are generally treated as financial products with relatively high creditworthiness.
However, they are not completely risk-free.
- Credit risk of the issuing country
- Price fluctuations caused by changes in market interest rates
- Losses from selling before maturity
- Decline in real value due to inflation
- Opportunity loss associated with fixed interest rates
In particular, for government bonds that can be traded on the market, the nature of the risk differs depending on whether they are held until maturity or sold before maturity.
Main Risks of Stocks
Stocks offer the possibility of capital gains and dividends from company growth, but their prices may fluctuate significantly due to various factors.
- Deterioration in company performance
- Economic downturn
- Interest rate changes
- Dividend reductions or suspension of dividends
- Corporate scandals
- Bankruptcy
- Decline in the overall market
Stock prices fluctuate not only because of the performance of the company itself but also because of the overall economy and market sentiment.
Main Risks of Investment Trusts and ETFs
The risks of investment trusts and ETFs vary depending on what the product invests in.
A product focused mainly on stocks is affected by stock price fluctuations, while a product focused mainly on bonds is affected by changes in interest rates.
If foreign assets are included, foreign exchange risk is added as well.
An investment trust is not necessarily safe simply because it is an investment trust, and an ETF is not necessarily safe simply because it is an ETF. It is necessary to check the underlying investments.
Main Risks of FX
In FX, it is mainly necessary to consider risks arising from foreign exchange fluctuations and leverage.
- Foreign exchange risk
- Leverage risk
- Forced liquidation
- Changes in swap points
- Changes in interest rate policy
- Sudden market fluctuations
- Widening spreads
In FX, even when holding a currency for the long term in order to receive swap points, a significant unrealized loss may occur if the value of the currency itself falls.
Main Risks of CFDs
CFDs also use margin like FX, so attention must be paid to the expansion of losses caused by leverage.
In addition, price movement characteristics differ depending on the underlying asset, such as stock indexes, crude oil, gold, or individual stocks.
- Price fluctuation risk
- Leverage risk
- Forced liquidation
- Holding costs such as interest adjustments
- Foreign exchange fluctuations when trading foreign markets
Different Financial Products Have Different Types of Risk
The main financial products and their representative risks can be summarized as follows.
| Financial Product | Main Risks |
|---|---|
| Ordinary deposits and time deposits | Inflation, creditworthiness of financial institutions, etc. |
| Government bonds | Credit, interest rates, prices, inflation, etc. |
| Corporate bonds | Corporate credit, interest rates, prices, etc. |
| Stocks | Price fluctuations, company performance, credit, liquidity, etc. |
| Investment trusts | Varies depending on the underlying investments |
| ETFs | Varies depending on the underlying investments |
| REITs | Real estate prices, interest rates, disasters, liquidity, etc. |
| FX | Foreign exchange rates, leverage, interest rates, forced liquidation, etc. |
| CFDs | Price fluctuations, leverage, forced liquidation, etc. |
The Level of Risk Can Vary Even Within the Same Type of Product
Financial products of the same type do not necessarily have the same level of risk.
In the case of stocks, financial conditions and price movements differ from one company to another.
Government bonds also have different characteristics depending on the issuing country, time remaining until maturity, and whether the interest rate is fixed or variable.
In FX, risk also changes significantly depending on the currency pair, leverage, position size, and amount of margin.
Therefore, it is necessary to check not only the name of the financial product but also the actual trading conditions.
It Is Difficult to Eliminate Risk Completely
In asset management, it is difficult to eliminate all risks completely.
Holding only cash or deposits makes it easier to avoid market price fluctuations, but there is still the risk of a decline in real value due to inflation.
Investing in stocks may provide the possibility of growth exceeding inflation, but price fluctuation risk becomes greater.
Government bonds may be suitable for relatively stable asset management, but they are affected by interest rates and inflation.
What is important is not to reduce risk to zero, but to understand which risks you are willing to accept and to what extent.
Reducing Risk Through Diversification
One method of managing risk is “diversification.”
Instead of concentrating all funds in a single product, funds are divided among multiple assets with different characteristics.
Example:
If all funds are invested in a single stock and that company’s stock price falls significantly, the entire portfolio will be greatly affected.
On the other hand, if funds are divided among deposits, government bonds, and multiple stocks, the impact of a decline in one asset on the entire portfolio may be reduced.
However, diversification does not guarantee that losses can always be prevented.
If the overall market declines significantly, multiple assets may fall in value at the same time.
Diversifying Investment Timing
In addition to diversifying investment targets, there is also a method of spreading purchases over time.
Instead of investing all funds at once, purchasing in several installments, such as every month, can help avoid concentrating funds at the price prevailing at a single point in time.
However, if prices continue to rise in one direction, investing the entire amount at once may result in a larger profit.
Separate Living Expenses from Investment Funds
When managing investment risk, it is also important to separate money needed for daily life from money used for investing.
If funds that will be needed in the near future are invested in products with price fluctuations, they may have to be converted into cash even when prices have fallen.
Therefore, one approach is to secure daily living expenses, funds needed in the near future, emergency funds, and other necessary money before considering investing funds that are not expected to be needed for the time being.
Consider Not Only “How Much Can I Make?” but Also “How Much Could I Lose?”
When comparing financial products, it is easy to focus on high yields or large potential profits.
However, the greater the expected return of a product, the more important it is to consider the possibility of large losses.
Therefore, before investing, it is important to check points such as the following.
- How much could the price potentially fall at most?
- Is there a possibility of losing principal?
- Can the product be sold before maturity?
- What happens if it is held until maturity?
- Is it affected by foreign exchange rates?
- Is leverage being used?
- Is there forced liquidation?
- Could interest or dividends decrease?
- Could the issuing company or country become unable to make payments?
Understanding “how losses occur” is just as important as understanding “how profits occur.”
Consider How Much Risk You Can Tolerate
Even with the same financial product, whether it is suitable differs from person to person.
A person who can continue holding an investment for a long period even with an unrealized loss of ¥100,000 can take a different level of risk from someone whose daily life would be affected by a loss of ¥10,000.
The level of risk that can be tolerated also changes depending on the investment period.
Funds that will be needed in several months and funds that are not expected to be used for more than 10 years allow for different choices of financial products.
In asset management, it is necessary to choose an investment method after considering how much price fluctuation and loss you can tolerate.
Summary
Risk in investing is not simply “the possibility of losing money,” but also includes the uncertainty of not knowing how much future prices or returns may fluctuate.
Different financial products involve different risks.
| Risk | Main Description |
|---|---|
| Price fluctuation risk | Market prices rise and fall |
| Credit risk | A country or company becomes unable to make payments |
| Interest rate risk | Bond prices and other values fluctuate according to market interest rates |
| Foreign exchange risk | The value converted into yen fluctuates according to exchange rates |
| Liquidity risk | It may not be possible to sell at the desired price |
| Leverage risk | Gains and losses become large relative to a small amount of capital |
| Inflation risk | Rising prices reduce the real value of money |
| Reinvestment risk | It may not be possible to reinvest under the same conditions after maturity |
Deposits, government bonds, stocks, investment trusts, FX, CFDs, and other financial products all involve some form of risk.
What matters is not eliminating risk completely, but understanding under what circumstances losses may occur and whether you can tolerate those losses.
When choosing a financial product, it is necessary to consider not only “how much profit may be earned,” but also “what could cause a loss and how large that loss could be.”
References
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