Investing in capital markets is associated with various risks. It is essential to develop an understanding of the risks of investing, financial instruments and financial services. The purpose of this document is to convey such an understanding.
You should always remember that:
- The value of your investments and any income from them can decrease or increase over time.
- You may get back less than the amount you originally invested.
- Past performance is not an indicator of future performance.
- Nothing is certain in capital markets.
- Both prices of investments and income distributions may fluctuate significantly.
- Fundamentals of Investing
Risk is about the probability and possible extent of losses of an investment. An investor must accept the possibility of taking losses in the investment process.
2.2. Relationship between Return, Security and Liquidity
To be able to choose an investment strategy you should understand the importance of the three pillars of successful investing:
- Return is the measure of economic success of an investment which is expressed in gains and losses.
- Security aims at preserving the value of the investment. The security of an investment depends on the risks associated with that investment.
- Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price.
Return, security and liquidity are inherently linked. A secure and liquid investment will, as a general rule, not generate high returns. A secure investment generating relatively high returns will probably not be liquid. A liquid investment generating high returns will regularly provide a low security. All in all, an investor must weigh these goals against each other depending on his/her individual preferences as well as personal and financial circumstances.
- General Risks
There are general risks to which all asset classes, financial instruments and financial services are exposed to and which may lead to a financial loss. Some of these risks are:
- Economic risk: The economic development moves in cyclical fluctuations. Cyclical downturns can reduce the value of your investment substantially.
- Inflation risk: Money is subject to decrease in value due to inflation.
- Country risk: The government of a country may exert influence on capital movements and the transferability of its currency and, thus, hindering a debtor to fulfil its obligations. If your investment includes assets affected by this risk, you might suffer a loss.
- Currency risk: This is a form of risk that arises from the change in price of one currency against another. Your investment might decrease in value even though the underlying asset has not decreased in value.
- Liquidity risk: Some investments may not be liquid and, thus, may not be sold ad hoc or sold only with reduction in value. If these investments must be sold on short notice, you might suffer a loss.
- Cost risk: Banks, credit institutions and financial services companies charge various costs/spreads which may substantially reduce the performance of your investment over time.
- Tax risk: Gains generated by investments in capital markets are subject to taxes and/or other fiscal liabilities. Changes of the law might lead to an unexpected value decrease of your investment.
- Risk of leveraged investments: Leveraged investments lead to increased risks in investing. If your investment decreases in value, you might not be able to cover interest or repayment claims.
- Risk of incorrect information: You may make misguided investment decisions due to missing, incomplete or incorrect information and, thus, suffer a loss.
- Foreign Exchange
Investments denominated in a foreign currency are a possibility to diversify your portfolio. In addition, investments in all other asset classes might be associated with foreign currency risks.
Investments in foreign currency are, inter alia, subject to the following risks:
Exchange rate risk: Changes in the exchange rate of different currencies may have a substantial influence on the performance of an investment. Even in the event of the investment performing well, the value might deteriorate for individual investors due to unfavourable exchange rates.
Interest rates: Changes in the rate of interest in the investors’ domestic market or foreign market may cause changes in the exchange rate due to considerable capital movements.
Regulatory risk: Regulatory authorities (e.g. Central Banks) play a decisive role in the fixing or management of its country’s exchange rate. They might intervene for macroeconomic reasons. This poses additional risks hard to foresee for the individual investor.
- Risks of Financial Services
For investing in capital markets, different financial services are available in the market. All of them are subject to of certain risks and conflicts of interest.
Execution only trading: The client makes their own investment decisions which are merely executed by the financial service provider. The client does not explain their circumstances to the financial service provider and the financial service provider does not give advice related to these transactions. The client risks making misguided investment decisions.
Investment advice: Investment advice is a personal recommendation that attempts to assist an investor regarding particular financial products and investment strategies. However, the adviser does not have ultimate discretion to execute the transactions. Some advisors are not fully independent and offer only restricted advice. This is where they advise on only a small portion of the total available market.
Discretionary investment management: An investment manager has discretion over both asset allocation and individual security selection in relation to the assets held in the client’s portfolio. Before providing the investment management services, the investment manager must assess the client’s individual risk preferences as well as personal and financial circumstances. The investment manager shall act in the client’s best interest. However, the investment manager may make misguided investment decisions or even behave fraudulently.
Updated: 12. August 2018