Investing is not without risks, and it is important that you know which risks are involved. Many people lose interest by the word ‘risk’, but that is not necessary. If you are going to invest carefully, taking into account the ‘golden rules of investing’ and minimizing the most common risks, then investing is smart. You want to prevent losing (part of) your investment, or have your investments suddenly drop in value. Again: you invest to build up long-term capital! Here we will point out the risks of investing and how to avoid them.
The risks of investing
When it comes to investing, 4 particular risks need to be into consideration.
- market risk
- specific risk
- credit risk
- costs too high
When you invest in index funds, your investments track the index, which is made up of hundreds of stocks or bonds. Therefore, you follow the development of the economy. The economy grows and shrinks and grows and shrinks (volatility). Which means that the value of your investments will also go up and down. The risk that your investments will lose value due to the economic situation is also referred to as market risk. This means that the entire market and basically all investments are decreasing in value. This happened recently in march 2020 when the corona crisis hit.
Tip 1: Only invest with money you don’t need
If you don’t need your money, you don’t have to sell your investments. And as long as you don’t sell your investments at a loss, they can increase in value again. This is important to remember: you only take a loss if you sell at a loss. Therefore, always keep the long term in mind and invest with money that you can afford to lose.
Tip 2: Spread your investment
What can be good for your investments is not to invest all your money at once, but rather in smaller steps. This way you spread your invested money over time: the price of your stock fluctuates, one day up, next day down.The future value of your investments is then less dependent on the moment of investment. But keep in mind that depending on the brokerage you choose, they might charge costs for every transaction. Ideally, you should try and keep your costs as low as possible.
Then you have ‘specific risk’. This risk does not relate to the entire market, but to the risk that specific companies might get into trouble and their stocks and bonds will lose value. For example, because the company produces something that consumers no longer need or a company does something unlawful and is fined for it. This risk applies to all types of investments.
You also have credit risk. This is the risk that a company or country in which you invest with bonds will (almost) go bankrupt and you will no longer receive credit (dividend or interest). When you invest in a company or country and they almost go bankrupt, they will no longer pay you interest on your investments, they become worthless.. If they go bankrupt, you will also lose your investment.
Tip 3: Do not put all your eggs in one basket – diversify
Specific risk and credit risk are largest when you only buy shares and/or bonds in one company. As you spread your investments across different companies in different sectors in different parts of the world, like you do with index funds, you minimize this risk. Should a company in which you have invested go bankrupt, there will be many left standing that you probably barely notice.
Costs too high
If the brokerage fees are higher than the expected return, there is a good chance that your investments will not yield you anything, only cost you money. It is good for the return on your investments if your costs are as low as possible. Besides paying too high transaction fees, excessive costs can also occur when you invest too little money. The fixed costs of investing can be quite high in percentage terms.
Tip 4: Hold onto your investments
You can reduce costs by not constantly buying and selling investments. If you regularly invest an amount and hold on to your investments, you pay less transaction costs than if you actively trade on the stock market every day. In general, active investors do not know better than passive investors what the future holds. After all, nobody has a crystal ball. So always keep the long term in mind and hold onto your investments.
Tip 5: Put in enough money
If you invest too little, but incur costs, your investments will be worth less. That’s why it’s important to invest. The less you invest, the more the costs weigh on your expected return. So the more you invest, the lower the costs weigh and the greater chance that your investments will achieve a better return and continue to grow. Nevertheless, this is not always the case. Some banks and brokerage charge a procentual fee on your transactions, and some charge a fixed fee. Do some proper research on the terms and conditions.
For example: if you invest €20 a month, but you pay €2 for each transaction, the cost per transaction is in percentages way higher than when you invest €200 a month with the same transaction costs.
Tip 6: choose the right bank or broker
Choosing a particular broker or bank can also make a huge difference. Do you pay a few euros per transaction, or can you do a transaction for free?
Investing has risks, that’s obvious. However, you can minimize the greatest risks with investing if you carefully shape your investment strategy, keep costs low, spread your investments well and maintain a long-term horizon.