Different Types of RiskSubmitted by Headwater Investment Consulting on May 4th, 2016
By Kevin Chambers
Investment risk is the probability of losses relative to the expected return on any particular investment, thus, risk an inherent aspect of investing. All portfolios contain some risk. The least risky option is to keep your money in the bank and have it be insured by the FDIC. As a general rule, the more risk you take on in your portfolio, the more potential return your investments can produce. But riskier portfolios are also subject to larger losses. Diversification of securities within an asset class and diversification across asset classes can mitigate some of the risks. Beyond that, it is important for each investor to find the appropriate amount of risk for their situation and tolerance.
Systematic risk is built into the market. It is a risk that affects an entire market place. The 2008 crash is an example of systematic risk. This type of risk is fairly unpredictable and affects most of the securities in the market. There can be a systematic risk in the stock market, bond market, or any other market. Systematic risk can be mitigated by diversification across markets.
Unsystematic risk is also called company risk. It is specific to an individual security or industry. It is the risk that something bad could happen to a company that an investor has invested in, for example, regulatory changes, product recalls, or bankruptcy. Unsystematic risk can be mitigated by diversification and investment in many different companies. Mutual funds are a good investment option to avoid unsystematic risk.
Credit risk (or default risk) the risk that a company will not be able to pay the interest on their corporate bonds. The ratings given to bonds are mostly based on the probability that company will default on their debt.
The risk that a government will default on their debt is country risk. When a government is unable to make their financial commitments, it can affect many aspects of the country’s financial system. Stocks, bonds, and other financial instruments based in that country can be affected by country risk.
This is a type of risk associated with investing in foreign countries. For international stocks or bonds, changes in the local currency versus the US dollar create currency risk. Some mutual funds that invest in foreign securities try to hedge out currency risk by buying currency futures, options, and derivatives. Some stocks and bonds are also offered in dollar denominated forms, which eliminates part of the currency risk.
Interest Rate Risk:
Interest rate risk is the possibility that the value investment will go down because of changes in interest rates. This is a risk that many financial professionals are currently concerned with as actions by the Federal Reserve will affect interest rates. This is a risk that affects bonds more readily than stocks: as interest rates increase, the values of bonds decrease.
Political risk is the chance that a government will take measures that will hurt a securities value. This could be new regulations, electoral changes, or nationalization of industries. This is a risk most associated with emerging market economies, but can affect all nations.