Types of investment risks

There are basically two categories of financial risk: The first is called Systematic Risk.

Systematic risk influences a large number of investments over a broad spectrum. The 2008 financial crisis would be a good example. Virtually all assets were negatively affected. It is almost impossible to protect yourself against this type of risk. In other words, sometimes lightning strikes.

The second is called Unsystematic Risk, also commonly called “Specific Risk”.

This is the type of risk that affects a smaller number of investments in a narrow spectrum. An example of this would be a highly regarded company using dubious financial practices (think Enron). Proper diversification is the key to providing protection against this type of risk.

Now we are going to explain in more detail the specific types of Unsystematic Risk that exist in the investment world.

Market risk

This is the type of risk you may be most familiar with. They are simply the normal fluctuations in the price of an investment. It is most evident in stock-related investments.

Simply put, it is the risk that an investment will lose value due to market forces. This is also sometimes called volatility, which is actually the measure of market risk. These movements in the markets are what provide the ability for an investor to earn money.

Credit risk

This is also known as default risk. This occurs when a person or entity (business/government agency, etc.) is unable to pay what they owe on their debt. It can be the principal or the interest. Corporate bonds tend to have higher default risk, but tend to pay higher rates of return in an attempt to compensate. Government bonds tend to have lower default rates but pay a lower rate of return. If a rating agency considers a bond to have a relatively low probability of default risk, then it is called investment grade. Conversely, if a bond is deemed by a rating agency to have a relatively high probability of default, it is referred to as a junk bond. This is a bit of a misnomer, as “junk bonds” can be a solid addition to an investment portfolio and can mitigate other types of risk.

Risk country

This refers to the inherent risk when a country cannot meet its financial commitments (think Greece). When a country fails to meet its obligations, the impact is often cascading in nature. That means that not only the country’s bonds will be affected, but also other financial assets within the country, such as the stock market in general. In addition, other countries or companies that do business with the defaulting company may also be affected.

currency risk

Investing in foreign countries offers many advantages, especially in terms of diversification. When investing in assets or debt of foreign countries, keep in mind that currency exchange rates can change the price of the asset or debt. Therefore, even if the asset increases in value when you exchange it for your local currency, you could suffer a loss. The reverse is also true: the asset might go down, but when you transfer it to your local currency, you might as well make a profit.

Interest rate risk

Refers to the risk when a change in interest rates affects the value of an asset or debt instrument. Generally, risk applies to bonds in a more direct way than to stocks. However, stocks, especially preferred, convertible, and high-dividend stocks, can also be affected. Other things being equal, as interest rates increase, the value of the bond will decrease.

political risk

This refers to the risk that occurs when a country’s policies change, especially if it happens randomly. For example, if a company is selling in country ABC and that country radically changes its tax laws and becomes hostile to business, companies doing business in that country may be adversely affected.

key takeaways

1) Risk cannot be avoided and must be understood.

2) Through proper planning and execution, you can mitigate risk and benefit from it.

3) Your goal is to minimize risk and maximize rewards.

4) Although the market rewards risk taking, that does not imply that the fact that an investment is high risk will be high reward. It has always been and always will be a trade-off.

5) Review all your investments to make sure you understand what kind of risks you have.

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