Capital Risk: What it is, How it Works in Investing

What Is Capital Risk?

Capital risk is the potential of loss of part or all of an investment. It applies to the whole gamut of assets that are not subject to a guarantee of full return of original capital.

Investors face capital risk when they invest in stocks, non-government bonds, real estate, commodities, and other alternative assets - where this is known as market risk. Additionally, when a company invests in a project, it exposes itself to the risk that the project will not produce future returns to cover the capital invested.

Understanding Capital Risk

Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment.

We all face risks every day—whether we’re driving to work, surfing a 60-foot wave, investing, or managing a business. In the financial world, risk refers to the chance that an investment’s actual return will differ from what is expected – the possibility that an investment won’t do as well as you’d like, or that you’ll end up losing money.

The most effective way to manage investment risk is through regular risk assessment and diversification. Although diversification won’t ensure gains or guarantee against losses, it does provide the potential to improve returns based on your goals and target level of risk. Finding the right balance between risk and return helps investors and business managers achieve their financial goals through investments that they can be most comfortable with.

Capital risk is often top-of-mind for project planners of a company. Capital budgeters analyze proposed investments in a project — a new product line or factory, for example — by modeling projected cash flows against the capital requirements of the project. The process of risk analysis will attempt to quantify capital risk by varying the model assumptions. No rational company will undertake a capital project if the model shows an unacceptable level of risk to capital invested. It should also be noted that a company may not choose to proceed with a project even if the NPV is projected to be greater than zero. For a firm to make an investment, its desired hurdle rate must be cleared.

Reporting Capital Risk to Shareholders

Registration statements that the Securities and Exchange Commission (SEC) requires for new securities have implicit or explicit language that prospective investors will assume capital risk by buying the securities.

Ongoing filings such as Form 10-K remind investors through the "Risk Factors" section that a number of risks exist that could result in the loss of investor capital. Firms with higher risk profiles - clinical-stage biotechnology firms, for example — typically discuss at length the potential for an investor to lose capital.

For example, Axovant Sciences Ltd.'s 10-K for the fiscal year 2017 contains 37 pages of risk disclosures. (Pfizer Inc., by contrast, carried only 13 pages of risk factors in its 10-K for the fiscal year 2016.) When Axovant filed its 10-K on June 13, 2017, the stock closed at $22.51 per share. On the last trading day of 2017, the stock closed at $5.27. The explicit statement in the 10-K that "the market price of our common shares has been and is likely to continue to be highly volatile, and you may lose some or all of your investment" turned out to be very prescient.