Types of Risk
There are two main types of risk:
- Systematic Risk - Systematic risk influences a large number of assets. A significant political event, for example, this could affect the overall market, not just a particular industry or stock. It is virtually impossible to protect yourself against this type of risk as it is both unpredictable and almost impossible to completely avoid. Diversification will not dampen the effects of this only hedging through the use of the correct assets at the time of the event.
- 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. As an example whilst some stocks in the mining sector might be falling in overall share price due to a falling commodity price for their raw products, you might also hold a telco or a bank share which could be having a rise in price due to people looking for alternatives to collect a higher paying dividend stock.
Other forms of risk can include but are not limited to:
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.
Country Risk - Country risk refers to the risk that a country won't be able to honour 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.
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.
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.