Different definitions are used to describe investment risk. One definition is simply the possibility of losing money on an investment. Another is the probability that the actual return of an investment will differ from its expected return. A third definition is the variability of returns from an investment compared to the investment’s average return (this means returns go up and down more than expected).
Total risk can be divided into two parts: systematic risk and unsystematic risk.
Systematic risk affects the prices of all comparable investments. Systematic, in this context, refers to the economic, political, and sociological factors that impact all securities to varying degrees. More simply, if you invest, you will be subject to systematic risk. You cannot diversify systematic risk away.
There are five types of systematic risk:
- Interest rate: caused by fluctuations in the general level of interest rates.
- Market: risk arising out of changes in the market price of securities. Investors tend to follow the direction of the market. As a result, market risk is the tendency of security prices to move together.
- Reinvestment rate: risk that market interest rates may have decreased at the time payments from an investment are received. For example, this impacts reinvesting in bonds and getting smaller interest payments.
- Purchasing power also known as inflation risk. Inflation eats away at an individual’s ability to purchase goods and services.
- Currency: also known as exchange rate risk. This is potentially a factor when investing in non-domestic instruments.
Also known as diversifiable risk, unsystematic risk represents the portion of investment risk that can be practically reduced or eliminated through diversification.
It is the portion of total risk that is unique to a firm, industry, or property. Such factors as a company’s management capabilities, financial structure, labor strikes, and consumer preferences cause unsystematic risk. Examples of unsystematic risk include business risk, financial risk, default risk, and liquidity (marketability) risk.
- Business risk: associated with a firm’s ability to operate profitably and therefore is a major risk with individual common stocks. The degree of business risk is a function of factors such as a company’s management (both ability and credibility), specific products or services, marketing strength, financial strength, accounting practices (conservative or aggressive), and its fundamental business plan.
- Financial risk: directly related to the amount of debt a firm has (shown on its balance sheet). A firm that is highly leveraged (large amounts of debt) has greater financial risk than a firm with little or no debt.
- Credit risk: the risk of loss from a borrower’s failure to meet a contractual obligation, for whatever reason. For example, if a bond issuer has insufficient cash flow to make the interest payments, or even principal payments on its bonds, investors will face losses.
- Downgrade risk: related to credit risk, as it is the risk that a bond (or a preferred stock) will be downgraded for problems such as excessive business risk and/or financial risk.
- Liquidity and marketability risk: related to the uncertainty of converting an investment into cash in a short period of time at, or near, the quoted market price.
- Event risk: the possibility that a security will be affected by an unanticipated and damaging event. The event may take the form of a major tax or regulatory change; a change in a company’s capital structure from a merger or buyout; disclosure of fraud or other significant misdeeds; negative media attention to a particular product found to be harmful or dangerous; or any other major, unexpected event for the company, either internal or external.
You can broadly categorize unsystematic risk either as business or financial. The preceding bullet points provide an expansion of these two categories.
Through diversification you can reduce unsystematic risk but not systematic risk. If you do choose to purchase individual stocks you can diversify effectively with around 20 stocks of different large-capitalization companies, but you don’t need to do that. By investing in a mutual fund, such as an S&P 500 index fund, you can approach full diversification with just the one investment.
This article provided a short overview of basic types of investment risk. There is more you can learn by doing your own research. Also, you can discuss risk with a trusted, professional advisor who can provide relevant answers as you build your investment portfolio.