There are always two sides to a coin – in the case of investments, the two sides are simply defined: there are opportunities and there are risks. In this section of our website my team and I would like to inform you about the risks of financial investments, because risks are part of every investment. It is particularly important for us that you as our client develop a clear understanding of the risks of investment products and financial services.
In principle, all investments offer opportunities for market, sector and company related price increases and of course risk diversification also means risk minimisation, but investments cannot yet completely exclude all risks.
The value of your investments or the prices of shares, investment funds or bonds and interest rates for loans are subject to fluctuations and a multitude of interactions, just like the returns flowing from them. It is therefore possible that you may not get back the full amount you invested. In extreme cases, depending on the financial instrument you choose, you may also suffer a total loss of your invested assets or be obliged to make additional payments.
For more detailed information, please contact us at firstname.lastname@example.org or on 0421 5650605 – 0.
Of course the aim of our cooperation with you is to help to maintain and increase your capital investment. It should be noted that the main difference between investments in capital markets and classic forms of savings (federal treasury bonds, savings books, overnight deposit or fixed-term deposit accounts, etc.) is the deliberate taking of risks in order to take advantage of profit opportunities. With classic forms of saving, on the other hand, the amount paid in is guaranteed, but the potential profit is limited to the agreed interest payment.
For my team and me, it is important that a capital investment strategy and the corresponding investment instruments focus on returns, security and liquidity.
“Return” is the measure of the economic success of a capital investment, which is measured in profits or losses. This includes positive price developments and distributions such as dividends or interest payments.
“Security” is aimed at preserving the invested assets. The security of a capital investment depends on the risks to which it is subject.
“Liquidity” describes the availability of the invested assets, i.e. in what period of time and at what cost the invested assets can be sold.
The objectives of return, security and liquidity interact with each other. An investment with high liquidity and high security does not usually offer a high return. An investment with high profitability and relatively high security is usually not liquid. An investment with high profitability and high liquidity usually offers little security.
An investor must weigh up these objectives according to his individual preferences and financial and personal circumstances. In making this assessment, investors should be aware that an investment that holds out the prospect of achieving all three objectives is difficult and rare to find.
For investments, it is particularly important not only to be aware of and consider the risks of individual assets or asset classes, but also to understand the interaction of the various individual risks in the portfolio context.
Taking into account the targeted return, the portfolio risk should be optimally reduced via an appropriate combination of investment instruments. This principle, i.e. the reduction of investor risk through an appropriate portfolio composition, is known as risk spreading or diversification. The principle of diversification follows the principle of not putting all your eggs in one basket. Those who spread their capital investment over too few investments expose themselves to unnecessarily high risk. Appropriate diversification allows the risk of a portfolio to be reduced not only to the average of the individual risks of the portfolio components, but usually also below it. The degree of risk reduction depends on how independently the prices of the portfolio components develop from one another.
The correlation expresses the extent to which the price fluctuations of the individual portfolio components are interdependent. In order to reduce the overall risk of the portfolio, investors should allocate their funds to investments with the lowest possible or negative correlation to one another. To achieve that objective, investments may be spread across regions, sectors and asset classes. In this way, losses of individual investments can be partially balanced out by the gains of other investments.
In addition to specific risks of individual asset classes, investment instruments and investment services, there are general risks associated with investments. Some are described below.
Business cycle risk: The development of an national economy typically takes the form of wave movements, the phases of which can be divided into upswing, high phase, downturn and low phase. This economic cycle and the intervention by governments and central banks that is often associated with it can last for several years or decades and have a significant impact on the performance of various asset classes. Economically unfavourable phases can therefore have a long-term negative impact on an investment.
Inflation risk: The inflation risk describes the danger of suffering a financial loss due to monetary devaluation. If inflation, i.e. the increase in the price of goods and services, is higher than the nominal interest rate on a financial investment, this results in a loss of purchasing power equal to the difference. In this case one speaks of negative real interest rates.
State risk: A foreign state can influence capital movements and the transferability of its currency. If, for this reason, a debtor domiciled in such a country is not able to meet an outstanding obligation (on time) despite its own solvency, this is referred to as a country or transfer risk. An investor can suffer financial loss as a result.
Currency risk: For investments in a foreign currency, the return achieved does not depend exclusively on the nominal return. It is also influenced by the development of the exchange rate between the foreign currency and the domestic currency. A financial loss can occur if the foreign currency in which the investment was made depreciates against the domestic currency.
Liquidity risk: Assets that can usually be bought and sold at short notice and whose buying and selling prices are close together are referred to as liquid. There are usually a sufficient number of buyers and sellers for these types of investments to ensure continuous and smooth trading. In the case of illiquid investments or in market phases in which there is insufficient liquidity, there is no guarantee that it will be possible to sell an investment at short notice and at low markdowns. This can lead to losses of capital if, for example, an investment can only be sold with price losses.
Cost risk: Costs are often neglected as a risk factor for investments. However, open and hidden costs are of essential importance for investment success. For long-term investment success, it is crucial to pay close attention to the costs of an investment. Credit institutions, other financial service providers and fund providers charge management fees, commissions and other costs.
Tax risks: Income from capital investments is generally subject to tax and/or duties for the investor. Changes in the tax framework for investment income can lead to a change in the tax and duty burden. In addition, double taxation may occur in the case of investments abroad. Taxes and duties therefore reduce the investor’s effectively realisable return. In addition, tax policy decisions can have a positive or negative effect on the overall price development of the capital markets.
Risk of credit-financed investments: Investors can obtain additonal funds for their investments by borrowing or lending their assets, with the aim of increasing the amount invested. This approach creates a leverage effect on the capital invested and can significantly increase the risk. If the value of the portfolio declines, it may not be possible to meet the additional funding obligations of the loan or the interest and redemption claims of the loan and the investor is forced to (partially) sell the portfolio. Credit-financed investments are therefore generally not advisable.
Risk Psychology of market participants: Rising or falling asset prices (e.g. of shares, bonds, real estate, commodities, etc.) always depend on the assessment of market participants. In addition to objective factors, their decision to buy or sell is also influenced by irrational opinions and mass psychological behaviour. This can lead to increasing movements in securities prices, for example, which cannot be economically justified but nevertheless lead to strongly positive (profits) or negative (losses) investment results.
Information risk: The information risk refers to the possibility of wrong decisions being made with regard to investments due to missing, incomplete or incorrect information.
Risks of exchange-traded investment funds
Risk of falling unit prices: The risk of fluctuation in an investment fund results from the risks inherent in the securities/assets making up the fund’s assets. Declines in the prices of the securities/assets included in the fund are reflected in the falling unit price of the fund.
Risk concentration: The more specialised a fund is, for example in certain securities, an asset class, region, industry, currency or risk factors, the more pronounced its risk/return profile. On the one hand, this means higher price opportunities; on the other hand, it is associated with a higher risk of loss and higher volatility.
Risk of failure: No investment fund can give a guarantee/assurance that the investment objectives, investment ideas and return expectations associated with its investment will actually be attained or achieved for its investors. There is always the possibility that the investment strategy pursued by an investment fund does not lead to the desired, targeted results or outcomes.
Fund management risk: In the case of investment funds, the investor only makes the decision regarding the selection of the investment fund. The actual fund management is the responsibility of the investment company and consequently so are the investment decisions. This means that the investor runs the risk of suffering losses due to incorrect investment decisions by the respective fund management.
Risk of restricted or suspended tradeability: When an investment fund invests in narrow-market securities, such as securities with a relatively low average daily turnover or securities for which there is no (regulated) secondary market, there is a risk that the price will be adversely affected or that it will not be possible to sell (or buy) the security at the desired time. In addition, the value of an investment fund’s investment fund assets may be reduced by cyclical and property-related fluctuations and by excessive withdrawal of liquidity. The Investment Company may therefore temporarily suspend the redemption of units if extraordinary circumstances arise that make a suspension appear necessary, taking into account the interests of the investors. This may temporarily restrict the tradeability of the investment fund (units) (from a few days and weeks to several years). In the event of a necessary revaluation or dissolution of the investment fund, there is also the risk of substantial discounts on the redemption price, up to the total loss of the invested assets.
Risk of globally investing investment funds: In the case of investment funds that also invest in securities denominated in foreign currencies or are managed in foreign currencies, it must be taken into account that, in addition to normal price developments, currency developments can also have a negative impact on the unit price and country risks can occur even if the securities in which the investment fund invests are traded on a German stock exchange. The appreciation of the euro ( depreciation of the foreign currency) causes foreign asset items to lose value when measured against the euro. The price risk of foreign securities is thus compounded by the currency risk. Currency developments can reduce a profit and impair the returns achieved to such an extent that an investment exclusively in euros or in asset positions in the euro zone might have been more advantageous under certain circumstances.
Cost risk: The investment in fund units may entail front-end loads and internal administrative and management costs. It should be noted that the amount of the front-end load and administrative and management costs may vary. Over a longer holding period, ongoing administrative and management costs add up and reduce the overall investment result. If the holding period is only short, the purchase of an investment fund with a front-end load can also lead to a significantly lower investment result than if it had been purchased without a front-end load. The front-end load and administrative expenses are not incurred or not incurred in the same amount when the underlying securities are acquired directly.
Securities lending risk: It is possible for investment funds to lend parts of the invested securities to other market participants in order to increase the return of the investment fund via the lending fee. Losses may be incurred by investors if the borrower is unable to return the borrowed securities and the collaterals provided are not sufficient to cover the potential loss.
Risk Misinterpretation of performance statistics: Performance statistics serve to provide a comparison of the management success of investment funds. However, they are subject to interpretation and are only to a limited extent suitable to reflect the investment success for the investor. For example, a front-end load is often not taken into account. Past performance data does not provide reliable support for a future-oriented investment decision.
Risk of transfer or termination of the investment fund: Under certain conditions, the investment fund may be transferred to another fund or the capital management company may terminate the management. In this case, the continuation on worse terms is possible and there is a risk that the investor will lose profits.
Risk of investment units being held for a too short period: The objectives associated with investing in investment funds do not set in the short term as a rule, but only in the medium to long term holding period, depending on the development of the international capital markets and the securities/assets contained in the investment fund. The premature redemption of investment units earlier than originally planned may lead to asset losses.
Risk of a change in the information or factual situation compared to the time of investment: A general change in the factual, market and legal situation can have a sustained and strongly negative impact on the investment result and the risk/return profile of an investment fund. A forecast of this or of the future income of an investment fund is generally not possible. The current and past performance of an investment fund does not allow any reliable conclusions to be drawn about its future performance.
Risks of open investment funds
Investment funds are instruments for collective investment in accordance with the provisions of the German Investment Code. A distinction must be made between open-end investment funds, which are open to an unlimited number of investors, and closed-end investment funds, which are open to a limited number of investors. A capital management company determines the investment strategy of an open-ended investment fund and manages the fund assets professionally. For reasons of investor protection, the fund assets must be strictly separated from the assets of the capital management company. For this reason, the assets belonging to the investment fund are held in a custodial account with the so-called depositary. Depending on the type of investment fund, the fund assets may consist of a wide variety of assets (e.g. securities, money market instruments, bank deposits, investment units and derivatives).
Investors may acquire a joint-entitlement to the fund assets at any time by purchasing investment unit certificates through a credit institution or the capital management company. Under certain circumstances, however, the capital management company may temporarily restrict, suspend or permanently discontinue the issue of fund units. The liquidation of the investment units can be carried out in two ways. First, it is generally possible to return the investment unit certificates to the capital management company at the official redemption price. On the other hand, the investment share certificates can be traded on a stock exchange if necessary. Third-party costs (e.g., front-end load, redemption discount, commission) may be incurred in the case of both the acquisition and liquidation of investment unit certificates.
The value of an individual share certificate is calculated by dividing the value of the fund assets by the number of issued share certificates. The value of the fund assets is usually determined according to a specified assessment procedure. For exchange-traded investment funds, the ongoing exchange trading is also available for pricing.
The key investor information, the sales brochure and the investment conditions provide information on the investment strategy, the running costs (management fee, operating costs, costs of the depositary, etc.) and other information of relevance to the open-ended investment fund. The issued semi-annual and annual reports are also an important source of information.
Foreign capital management companies can be legally structured differently to their German counterparts. However, if these foreign capital management companies distribute open-ended investment funds in Germany, they must meet certain legal requirements and are subject to supervision by German supervisory authorities.
The different types of open-ended investment funds can be differentiated according to the following criteria:
Composition: The fund assets may be composed of various asset classes (e.g. equities, interest-bearing securities, commodities).
Geographical focus: Open-ended investment funds may either focus on specific countries or regions or invest globally.
Temporal holding period: Open-ended investment funds may have a fixed or unlimited holding period.
Appropriation of Returns: Open-ended investment funds may distribute returns regularly or use them to increase the fund’s assets (reinvest).
Currency: The prices of the investment unit certificates of open-ended investment funds may be offered in euros or a foreign currency.
Hedging: The capital management company or a third party can guarantee a certain performance, certain distributions or a certain preservation of value.
Risks of bonds and fixed-interest securities
Creditrating-/Issuer risk: Interest-bearing securities (bonds) are issued by the issuer. If the creditworthiness (credit rating) of the issuer declines or the issuer becomes insolvent, a loss of value or default with regard to the investment may occur. A high rating does not guarantee the creditworthiness or solvency of the issuer – credit ratings are subjective.
Interest rate/price risk: The price development of a bond is related to the development of the market interest rate level. The development of market interest rates is influenced by government budgetary policy, monetary policy, inflation, the economy, foreign interest rates and exchange rate expectations. The longer the remaining time to maturity of the bond and the lower the nominal interest rate, the stronger the effect. If market interest rates rise, the investor is exposed to a price loss.
Risks of real estate
Illiquidity: Investments in real estate represent a relatively illiquid form of investment. This is primarily due to the high level of its individuality. Real estate differs greatly based on many factors (location, usable area, size, etc.). As a result, the process of assessment, sale & transfer of ownership is much more lengthy compared to other forms of investment. Investments in market-traded REITs reduces illiquidity.
Earnings risk: The acquisition of real estate is a costly investment that is amortized over the long term through the regular income of cash flows (e.g. rent or lease). This carries the risk that rental or lease payments may be temporarily suspended or cancelled altogether due to limited usability, which means that the initial investment cannot be further amortised.
Assessment Risk: Due to the high degree of individuality of real estate, many different influencing factors are decisive for a property assessment. As a result, many imponderables can arise in a property appraisal that are difficult to assess. It can even happen that different appraisals lead to different appraisals.
Loss of value: One risk that is often underestimated by many private investors is the loss of value. Just like other forms of investment, real estate can also decrease in value. This can have both individual and macroeconomic reasons. For example, the price of a property also depends on the Real Estate market as a whole. Despite greater individuality and low liquidity, there is also a market for real estate that primarily determines the average price level of real estate. If this market is subject to pressure, the value of the property may fall. This is a particular risk if a real estate loan is still outstanding and there has been speculation on further price rises.
Risk of securities/shares
Insolvency risk: The buyer of a share is an equity investor and thus a shareholder of a stock corporation. He participates in the economic development of the company. There is the entrepreneurial risk that the stock corporation develops economically differently than expected and that the investor does not get back the capital invested. In the most extreme case, the insolvency of the company, the invested amount may be lost completely.
Share price risk: Share prices are subject to unforeseeable fluctuations. The development of the share price is influenced by market developments and the company’s performance. In the short and medium term, the influences of current events and economic, currency and monetary policy may overlap.
Dividend risk: If the profits or losses of the stock corporation are low, the dividend may be reduced or cancelled altogether. Past dividend payments are not a reliable indicator of future dividend income.
Risks of commodities
Counterparty risk: When commodities are traded via derivatives, so-called counterparty risks arise. For example, if the counterparty is unable or unwilling to meet its payment obligations under the derivative contract, the investor may incur losses.
Price risk: Both direct investments and indirect investments via derivatives in commodities are exposed to price risks. In addition to economic factors, political and climatic factors also play a decisive role in commodity prices. Political conflicts, such as wars and natural disasters, can have a significant negative impact on the availability and thus the price of individual commodities.
Risks associated with ETFs
Replication risk (physical replication): There may be differences between the value of the underlying index and the ETF or index fund. In addition to transaction costs associated with the index composition, the timing of dividend payments and tax treatment may also have a negative impact on the performance.
Counterparty risk (synthetic replication): In the case of synthetically replicating ETFs, there is a risk that the swap counterparty may be unable to meet its payment obligations. This can lead to losses for the investor.
Off-market trading risk: If transactions in ETFs or the underlying components are executed outside trading hours, there is a risk that the performance of the ETFs or the underlying components will deviate from that of the underlying index. This can occur if the ETFs and their underlying components are traded on several exchanges with different trading hours.
Foreign currency risks
Investments in foreign currencies, for example Japanese yen, Australian dollar, US dollar or Swiss franc, offer investors an opportunity to diversify their portfolio. In addition, investments in the asset classes mentioned above are often associated with the possibility of taking on foreign currency risks. For example, if a German investor invests directly or indirectly in American equities, his investment is subject not only to equity risks but also to the exchange rate risk between the euro and the US dollar, which can have a positive or negative effect on the value of his investment.
Exchange rate risk: Exchange rates of different currencies can change over time and considerable exchange rate fluctuations can occur. For example, if a European investor invests in the US dollar or in a share listed in US dollars, a depreciation of the US dollar against the euro (i.e. an appreciation of the euro) will have an adverse effect on his investment. Under certain circumstances, even a positive share price development can be overcompensated by the depreciation of the US dollar.
Interest rate risk: Changes in interest rates in the domestic or foreign currency market can have a significant impact on the exchange rate, as changes in interest rate levels can sometimes trigger large cross-border capital movements.
Regulatory risks: Federal Reserve Banks play a fundamental role in the development of exchange rates. In addition to money supply and interest rates, some central banks also control exchange rates. They intervene in the markets as soon as certain thresholds are reached by selling or buying their own currency, or they tie all or part of the exchange rate to a foreign currency. If these strategies are changed or abolished, this can lead to considerable distortions in the corresponding foreign exchange markets.
Risks of CFDs
For a CFD the investor does not have to buy the underlying security, but only deposit a margin. The amount of this margin varies from broker/bank to broker/bank and determines the leverage. CFDs are futures market products, such as futures. They can be bought (long) and sold (short) without the investor having to hold positions. Thus, the investor can also participate in falling prices of shares, indices, currencies and commodities.
Risk of Total Loss: Trading CFDs involves considerable risks and can result in the total loss of your entire capital investment. There are some account types where losses may exceed the capital invested. Leveraged CFD trading may not be suitable for you!
Incalculable losses: the customer and the bank have mutual claims to equalise the difference in the price of the underlying asset at different times in cash. The decisive factor here is the price of the underlying asset when the CFD position is opened (by concluding the contract) on the one hand and at the time of closing the CFD position on the other. If the customer’s market expectation fails to be realised, the customer shall owe the difference between the price of the underlying asset at the opening and the current price of the underlying asset at the closing of the CFD position.
Leverage risks: Through margin trading (trading with leverage), a considerable part of the position is financed by credit. The risk of loss can include the entire capital investment in the form of the credit balance held in the CFD account for the purpose of CFD trading. There is therefore a risk of total loss. The account manager shall carry out a forced closing of CFD positions in the event of insufficient credit on the CFD account exclusively in his own interest; the customer cannot derive any rights from the possibility of a forced closing. Therefore, please consider that possible losses can be significantly higher than the funds that have been invested.
Risks of transaction orders
Price risk: The relevant unit (security) price may change adversely between the time the order is placed and the actual execution via the Investment Company or via the stock exchange. Even though orders are generally executed quickly and reliably, delays or disadvantageous changes in unit prices after the order has been placed cannot be completely ruled out.
Risk of price suspension: In special situations, the stock exchange or the investment company may temporarily suspend price setting, for example to prevent sharp price fluctuations or because no prices can be determined for individual assets within the investment fund’s assets themselves. On a domestic stock exchange, a buy or sell order is not executed in this case and expires. At a foreign stock exchange, the respective legal and business conditions apply. If a transaction order is placed with the respective investment company, the latter may defer execution or refuse it altogether.
Risks of execution-only transaction
In the case of an execution-only transaction (also referred to as “execution only”), the depositary bank only acts at the customer’s instigation when executing securities orders. There is no advice or review of appropriateness. Due to legal regulations, pure execution transactions may only be carried out for non-complex financial instruments (e.g. shares, money market instruments, bonds or public funds). Upon execution, the client receives a securities statement containing the key execution data (in particular type of order, name of the securities, number of units / nominal amount, transaction value, place and time of execution, execution price, settlement date).
Risks of consulting-free business
An advice-free transaction exists if the customer makes an investment decision without first having received an investment recommendation from a bank. The bank’s exploration obligation is considerably reduced compared to investment advice or financial portfolio management. In contrast to the pure execution business, however, there is at least a limited exploration obligation.
Risks of investment and acquisition brokerage
No advice is given to the client in the case of investment and contract brokering. Only a financial product is brokered for the customer. It is not necessary to check the suitability of the financial investment for the customer and therefore no or only a small amount of advice is given. In the case of brokerage, the financial product to be brokered is typically advertised exclusively or predominantly. In doing so, the customer may falsely be given the impression that this is investment advice. The remuneration for an investment and contract mediation usually takes the form of a reimbursement from the provider or issuer of the financial product directly to the mediator, for example through a commission included in the financial product or a premium to be paid by the customer.
Investment advice risks
When providing investment advice, an investment advisor recommends certain securities for the customer to buy or sell. The advisor is obliged to check the suitability of the recommended investment for the customer, taking into account the investment objectives, financial situation, risk tolerance as well as his knowledge and experience, and to record this in an advisory protocol. However, the decision to implement the advisor’s recommendation must be made by the customer himself. The customer must act on his own for each transaction and may need to seek further advice. The advisor is not obliged to constantly review the investment recommendation or the client’s portfolio.
There are basically two remuneration models: fee-based and commission-based consulting. The remuneration of both types of investment advice has a potential for conflict. With fee-based advisory services, the advisory service is usually charged directly to the client on a time basis. This gives the advisor the incentive to charge for as many consulting hours as possible. In the case of commission-based advice, the service is not charged directly to the customer, as the adviser receives a commission from his employer or from the provider of the investment product (e.g. the investment company or the issuer of a certificate). This entails the risk that the customer is not offered the most suitable security for him, but the most lucrative one for the adviser.
Asset management risks
Asset management is fundamentally different from investment advice or brokerage. The asset manager receives the authority from the client to make investment decisions based on his own judgement if he considers them appropriate for the management of the client’s assets.
However, he may not, in principle, acquire ownership of the client’s assets or transfer them to custody accounts or accounts not belonging to the client. When making investment decisions, the asset manager does not need to obtain any instructions from the client, but is nevertheless bound by the previously agreed investment guidelines.
Furthermore, asset management involves risks for the client’s financial situation. Although the asset manager is obliged to act in the best interests of the client at all times, wrong decisions and even misconduct can occur. The asset manager cannot guarantee success or avoid losses. Even without intent or negligence, the agreed investment guidelines may be violated by market changes.
Asset management requires the permission of the Federal Financial Supervisory Authority (BaFin). In the application for permission, the BaFin examines, among other things, the suitability of the management, but it expressly does not approve or authorize the services or products specifically offered.
As regulated financial services institutions, asset managers licensed in Germany are members of the Entschädigungseinrichtung der Wertpapierhandelsunternehmen (EdW). The EdW pays compensation if a securities trading company is no longer able to meet its liabilities from securities transactions with its customers and the BaFin has determined that a case of compensation exists. For these claims the protection is limited to 90% of the claims, but to a maximum of 20,000 euros per investor. However, the risk of asset management in breach of duty or misuse of power of attorney by the asset manager is not covered by the EdW.
Total loss risk
The characteristics and aspects of investments described above show that every investment and every investment fund has both opportunities and risks. Accordingly, no investment fund is completely safe and no investment fund can completely rule out the risk of total loss. In extreme cases, a total loss risk therefore also exists for investment funds that can be classified in product category 1 (risk category 1 – low risk). The risk of total loss is understood to mean the complete loss of the invested capital plus any costs and taxes paid.