Opportunities bring always a certain degree of risk. You probably know this from your personal experience. Each person ticks a little different in terms of risk and each person has his own level at which he feels comfortable. In principle, all capital market investments are linked to certain risks. The explanations given here are intended to provide you with a basic understanding of the potential risks. For detailed information, please contact our support at: firstname.lastname@example.org
When investing in financial instruments, there are general risks that apply to all asset classes and services in connection with the investment. Some of these risks are described below.
The macroeconomic development of an economy typically takes place in wave movements, which can be subdivided into following phases: recovery, peak, downturn and recession. These economic cycles – and the interventions of governments and central banks often associated with them – can last several years or decades and have a significant impact on the performance of different asset classes. Unfavorable economic phases can therefore have a long-term impact on a financial investment. In particular, if the investor does not take account of the economic trend in his investment decisions.
The inflation risk is the risk of suffering financial losses through currency devaluation. If inflation – i.e. the positive change in prices for goods and services – is higher than the nominal interest rate of a financial investment, this results in a loss of purchasing power equal to the respective difference.
A foreign state can influence the movement of capital and the transferability of its currency. If a debtor resident in such a country is not able to meet an obligation despite its own solvency, this is referred to as a country or transfer risk. Thereby an investor can suffer financial loss.
In case of investments that are denominated in a currency other than the investor’s home currency, the return achieved on the investment does not depend solely on the nominal return of the investment. It is also influenced by the development of the exchange rate between the foreign currency and the home currency. The investor may suffer financial loss if the foreign currency (in which the investment was actually made) is devalued against the domestic currency.
The liquidity risk of an investment describes the risk for an investor not being able to sell his securities at normal market prices at all times. In cases where there are only a few and very different orders (supply and demand) for a security, a market is described as illiquid. In this case, the immediate execution of purchase or sale orders is not possible or only to unfavorable conditions. As a general rule, one can say, that an average large selling order leads to noticeable price fluctuations or can only be executed at a significantly lower price.
When buying and selling financial instruments, some costs are not priced into the current price of the financial instrument. These additional costs can be divided into three categories. The first category includes costs directly related to the transaction (e. g. transaction costs or commissions). The second category is described by follow-up costs (e. g. custody account management fee). The third category includes running costs (e. g. management fees for investment funds). The level of these costs directly influences the realizable yield of an investor.
Income from financial assets is taxable. Changes in the tax framework can lead to a change in the tax burden. In case of investments abroad, double taxation may also occur. Taxes and duties thus reduce the effective yield that can be achieved by the investor. In addition, tax policy decisions can have a positive or negative effect on the price development of the capital markets.
Risk of credit-financed assets:
Investors may be able to obtain additional funds for the investment by borrowing or lending their financial instruments. This procedure creates a leverage effect on the capital employed and can lead to an increase in risk, which can be even more pronounced if the credit-financed financial instrument itself has a leverage effect (e. g. warrants). In the event of a fall in the value of the financial instrument, it may no longer be possible to meet the obligation to make additional contributions to the loan or to service interest and redemption claims on the loan and the investor will be forced to sell (partial-sell) the financial instruments. In extreme cases, this can lead to substantial losses and even to total losses of the invested capital.
In addition to the general risks, the following risks may arise when investing in equities:
A shareholder is not a creditor, but an equity investor / co-owner of a stock corporation and is therefore exposed to all entrepreneurial risks. In extreme cases, i. e. in the event of an insolvency of the stock corporation, shareholders will therefore only participate in the liquidation proceeds after all creditor claims have been satisfied.
General market risk (price change risk):
The general market risk of a share is the risk of a price change due to the general movements of the stock market. Thus, the price of a company can fall, even though the economic circumstances have not changed. In such cases, dependence on the overall market determines the direction of the price.
Company-specific risk (price change risk):
Company-specific risk refers to the risk of a decline in the share price of an individual company due to factors that directly or indirectly affect the company. For example, management decisions can be listed as such factors. The company-specific risk can therefore lead to share prices taking a very individual course against the general trend.
Dividends refer to shareholders’ participation in the profits of a company. The dividend of a share depends to a large extent on the company’s earnings and can rise, fall or be cancelled in one year depending on the financial situation of a company.
Psychological market risk:
The general price developments on the stock exchange are very often influenced by irrational factors. Moods, opinions and rumours can cause a significant decline in the share price, although the earnings situation and future prospects of the company didn’t change at all.
Risk of loss or change in membership rights and delisting:
The rights of the shareholder may be amended and/or partially or completely revoked by measures taken by the company (such as a change of legal form, mergers, spin-offs or due to certain company contracts). In addition, some minority shareholders can be excluded from the company in cases when there is a major stakeholder on board and if he forces a so-called squeeze-out. These measures by the company may result in the investor having to sell his shares at an early stage with losses and he may not be able to realize the intended investment period. Furthermore, the company may decide to delist its shares. In this case, the shares are only tradable with considerable markdowns, which is difficult. Due to this limited tradability, the announcement of a delisting regularly leads to significant price losses for the respective share.
In addition to general risks, following risks may arise when investing in ETFs:
Since ETFs replicate an underlying index and are not actively managed, they generally bear the basic risks of the underlying indices. ETFs therefore fluctuate directly and proportional to their underlying. The risk/return profile of ETFs and their underlying indices is therefore very similar. For example, if the DAX falls by 10%, the DAX ETF will also fall by around 10% (or in the case of a short ETF, rise by around 10%).
The investment risk increases with the increasing usage of an ETF of a certain region, industry or currency. However, this increased risk can also lead to increased earnings opportunities.
Exchange rate risk:
ETFs contain exchange rate risks if their underlying index is not quoted in the currency of the ETF. If the index currency weakens against the ETF’s currency, the performance of the ETF will be adversely affected.
ETFs are also subject to a replication risk, i.e. there may be deviations between the value of the index and the ETF (tracking error). This tracking error may exceed the difference in performance caused by the ETF fees. Such a deviation can be caused, for example, by cash holdings, new weightings, capital measures, dividend payments or the tax treatment of dividends.
In case of synthetic replicating ETFs, there is a counterparty risk. If a swap counterparty fails to meet its payment obligations, the investor may incur losses.
If ETFs and their underlying components are traded on different exchanges with differing trading hours, there is a risk that transactions in these ETFs will take place outside the trading hours. This may lead to a deviation in the performance of the underlying index.
An investment fund can enter into securities lending transactions to optimize returns. If a borrower is unable to meet his obligation to return the units and the collateral provided has lost value, the investment fund is at risk of losses.
Risk of transfer or termination of the fund:
Under certain conditions, it is possible to transfer the investment fund to another fund as well as terminate the management by the capital management company. In the event of a transfer, continued management may take place on less favorable terms. In the event of termination, there is a risk of (future) loss of profits.
The aim of asset management is to maintain or increase client assets. For this purpose, the asset manager shall be granted an authority by the client to make investment decisions at his own discretion if he considers them appropriate for the management and the agreed objectives.
Within the framework of this process, asset management also involves some risks for the client’s asset situation. In principle, the asset manager cannot guarantee a certain success or avoid losses. Although the asset manager is obliged to act always in the best interests of the client, this may lead to wrong decisions or misconduct on the part of the asset manager. Even without intent or negligence on the part of the asset manager, a violation of the investment guidelines may occur, for example, due to changes in the market.
© Fundamental Capital GmbH 2018 | Investing in financial markets involves risks. All rights reserved. Please read our risk disclosure.