RISK & DIVERSIFICATION: Different Types of Risk
Let's take a look at the two basic types of risk:
Systematic Risk - Systematic risk influences a large number of assets. A
significant political event, for example, could affect several of the assets in
your portfolio. It is virtually impossible to protect yourself against this
type of risk.
Unsystematic Risk - Unsystematic risk is sometimes referred to as
"specific risk". This kind of risk 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, let's look at more
specific types of risk, particularly when we talk about stocks and bonds.
Credit or Default Risk - Credit risk 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 bonds in their portfolios. Government bonds, especially those issued by
the federal government, have the least amount of default risk and the lowest
returns, while corporate bonds tend to have the highest amount of default risk
but also higher interest rates. Bonds with a lower chance of default are
considered to be investment grade, while 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. (To read more, see Junk Bonds: Everything You Need To Know, What Is A
Corporate Credit Rating and Corporate Bonds: An Introduction To Credit Risk.)
Country Risk - Country risk refers to the risk that a country won't be able
to honor its financial commitments. When a country defaults on its obligations,
this 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. (For related reading, see What Is An
Emerging Market Economy?)
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 - Interest rate risk is the risk that an investment's
value will change as a result of a change in interest rates. This risk affects
the value of bonds more directly than stocks. (To learn more, read How Interest
Rates Affect The Stock Market.)
Political Risk - Political risk represents the financial risk that a
country's government will suddenly change its policies. This is a major reason
why developing countries lack foreign investment.
Market Risk - This is the most familiar of all risks. Also referred to as
volatility, market risk is the the day-to-day fluctuations in a stock's price.
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
there is that it will experience a dramatic change in either direction.
As you can see, there are several types of risk that a smart investor
should consider and pay careful attention to.
