Investing: Different Types of Risk
There are two basic types of risk:
Systematic Risk - A risk that influences a large number of assets. An
example is political events. It is virtually impossible to protect yourself
against this type of risk.
Unsystematic Risk - Sometimes referred to as "specific risk". It's risk
that affects a very small number of assets. An example is news that affects a
specific stock such as a sudden strike by employees. Diversification is the only
way to protect yourself from unsystematic risk. (We will discuss diversification
later in this tutorial).
Now that we've determined the fundamental types of risk lets look at more
specific types of risk, particularly when we talk about stocks and bonds:
- Credit or Default Risk - This is the
risk that a company or individual will be unable to pay the contractual
interest or principal on its debt obligations. This type of risk is of
particular concern to investors who hold bond's within their portfolio.
Government bonds, especially those issued by the Federal government, have the
least amount of default risk and least amount of returns while corporate bonds
tend to have the highest amount of default risk but also the higher interest
rates. Bonds with lower chances of default are considered to be “investment
grade,” and bonds with higher chances are considered to be junk bonds. Bond
rating services, such as Moody's, allows investors to determine which bonds
are investment-grade, and which bonds are “junk”.
- Country Risk – This refers to the
risk that a country won't be able to honor its financial commitments. When a
country defaults it can harm the performance of all other financial
instruments in that country as well as other countries it has relations with.
Country risk applies to stocks, bonds, mutual funds, options and futures that
are issued within a particular country. This type of risk is most often seen
in emerging markets or countries that have a severe deficit.
- Foreign Exchange Risk – When
investing in foreign countries you must consider the fact that currency
exchange rates can change the price of the asset as well. Foreign exchange
risk applies to all financial instruments that are in a currency other than
your domestic currency. As an example, if you are a resident of America and
invest in some Canadian stock in Canadian dollars, even if the share value
appreciates, you may lose money if the Canadian dollar depreciates in relation
to the American dollar.
- Interest Rate Risk - A rise in
interest rates during the term of your debt securities hurts the performance
of stocks and bonds.
- Political Risk - This represents the
financial risk that a country's government will suddenly change its policies.
This is a major reason that second and third world countries lack foreign
investment.
- Market Risk - This is the most
familiar of all risks. It's the day to day fluctuations in a stocks price.
Also referred to as volatility. Market risk applies mainly to stocks and
options. As a whole, stocks tend to perform well during a bull market and
poorly during a bear market—volatility is not so much a cause but an effect of
certain market forces. Volatility is a measure of risk because it refers to
the behavior, or “temperament,” of your investment rather than the reason for
this behavior. Because market movement is the reason why people can make money
from stocks, volatility is essential for returns, and the more unstable the
investment the more chance it can go dramatically either way.
- Inflation Risk - Because the cost of
living increases each year (call inflation), some years a little, some
years a lot, you need to get some return on your investments equal to or above
the inflation rate, or your savings and investments will lose ground. For
example, if you keep your money in a savings account or a certificate of
deposit that is earning 6% and the inflation rate is 4%, your real return is
only 2%. If it is earning less than the inflation rate, you are really losing
money. You may have reasons to do this in the short run, but in the long run,
it is not a good idea.
As you can see, there are several types of risk
that a smart investor should consider and pay careful attention to. Deciding
your potential return while respecting risk is the age old decision that
investors must make.
How Much Risk Are You Willing To Take?
Besides a broad understanding of risk, ask yourself what your risk tolerance is.
To be a good investor, not only must you know where you stand financially, it's
also crucial to understand your own investment psychology.
To find out your risk tolerance level, think of your past experiences,
especially those related to your work and finances. (Some people drive very fast
but can't make financial decisions.) If you had changed your job without
thinking whether the return prospect would be worthwhile, your risk tolerance
should be quite high. But if you're the type who checks the price of item in at
least 3 or 4 shops before buying one, you're quite careful with your money.
Knowing your risk tolerance is critical for choosing suitable investment options
and making investment decisions. If you're inclined toward a high- risk-high-
reward stake, keep reminding yourself and draw a clear loss-limit. This doesn't
imply giving up your appetite for risk since risk takers may have different
views from others.
If you're a conservative investor and take quite a long time to make a decision,
the plus side of this is that you won't invest rashly. On the other hand, your
may miss out on a good investment proposition. Your risk tolerance is a thing
that you must find out for yourself. And perhaps you may allow yourself to be a
little more adventurous. But set a limit to it. (It usually happens that neither
the risk taker nor the risk averse has set his loss limit, hence he has problems
in trying to control his investment decisions and investment options.)
Whatever your attitude to risk, the decision and consequence is yours and yours
only. And the proof of it will be your return and time targets. There are many
good things in life. Don't let investment anxiety cause you ulcers or
sleeplessness!
Next-->>
Benefits of
Diversification and Asset Allocation
Table of Contents
-
What is investing?
-
How to choose the best investment
-
Concept of investment return and Rule of 72
-
Investment Risks & Rewards
-
Different types of Risk
-
Benefits of Diversification & Asset Allocation
-
Questions you need to ask before investing
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