3) Risk and Diversification: Different Types of Risk
There are two basic risk types:
- Systematic risk
- Unsystematic risk
Risk that could affect a broad spectrum of assets is called systematic risk. For example, a political event has the potential to impact many assets in your portfolio. This type of risk is almost impossible to protect yourself against.
The other type, unsystematic risk, is often called as “specific risk”. It affects only a narrow, specific range of assets. One example of this is news of a sudden employee strike affecting only a specific stock. Diversification of your investment portfolio is a means of protection against this type of risk, as it can mitigate the impact of this type of risk.
Now we take a look at specific risk types especially when talking about stocks and bonds.
- Creditor or Default risk: Credit risk is the risk that a company or individual will be unable to pay the principal on its debt obligations. This is of particular concern to investors whose portfolios hold bonds. Government bonds, particularly those which are issued by the federal government, have the least amount of risk but the lowest returns. Inversely, corporate bonds have the highest amount of risk but have high interest rates. Investment grade bonds are those with a lower chance of default, while those with higher chances are called junk bonds. Moody’s, which offers bond rating services, allows investors to determine which bonds are investment grade and those which are junk.
- Country Risk: The risk which a country won’t be able to honor its financial obligations is called country risk. If a country defaults on its obligations, it can harm all other financial instruments in that country including other countries it has relations with. This type of risk applies to mutual funds, stocks, bonds, options and futures issued within a country. It is most often seen in emerging markets or countries with severe deficit.
- Foreign-Exchange Risk: The price of assets is affected by currency exchange rates, so this must be taken into consideration when investing in foreign countries. Foreign exchange risk refers to all financial instruments in a currency other than one’s domestic currency. For example, if you are an American and decide to invest in Canadian stock in Canadian dollars, even if the value per share appreciates, if the Canadian dollar depreciates in relation to the American dollar, you may end up losing money.
- Interest Rate Risk: The risk that an investment’s value will change due to change in interest rates is called interest rate risk. This type of risk has a greater affect bonds than it does on stocks.
- Political Risk: If a country’s government suddenly changes its policies, the financial risk is called political risk. For this reason, most developing countries with less stable government policies will have fewer foreign investments coming in.
- Market Risk: Also referred as volatility, this is the most familiar of all risks. Market risk is the everyday fluctuations in a stock’s price, and it applies mainly to stocks and options. Stocks usually perform better during a bull market and poorly during a bear market. Volatility can be described as not so much as a cause, but as an effect of some market forces. It is a measure of risk because it pertains to behavior of one’s investment rather than reason behind the behavior. Volatility is needed for returns, since market movement is the means by which investors can make money from stocks. The more unstable the investment, the more chance there is that it will experience a sudden change in either direction.