When I first started investing I was well aware that there were risks involved but I had the most basic idea that risk was simply the threat of stock going lower then what you paid for it thus creating a loss. I had no real idea of how varied risks were and how to manage it. Because of that lack of knowledge, my first year had mixed results and thankfully were not totally devastating but did keep my overall returns flat because I did not know how to manage the stocks that were falling. When I delved into the subject of investment risks I learned just how many types of risks were present.
There is two categories of risk, unsystematic and systematic. Unsystematic risks can be lessened through diversification of the portfolio as opposed to systematic risks that do not respond to diversification.
Examples of unsystematic risks are:
Business/Financial Risk: This risk is specific to a company or industry. Company profits can change based on management decisions or industry trends. Financial risk comes into play when companies take on to much debt and management perceptions of the company’s ability to repay is misjudged.
Event Risk. This risk is caused by an unforeseen event that impacts the company’s finances like tax law changes or regulation changes. Also lower then expected quarterly earnings and revenue surprises are event risks.
Political Risk. This risk primarily applies to forgein stocks where changes in political and economic climates are not stable
Liquidity Risk. This is the risk of not being able to sell an asset quickly near or at the market price. U.S. stocks are considered the most liquid but even in the U.S. volume levels must be considered for quick exits.
Examples of systematic risks are
Inflation Risk. This risk applies primarily to bond, CD’s and other fixed income type investments. Erodes your buying power if inflation exceeds returns set on the fixed income instruments.
Reinvestment Risk. This is the opposite of the inflation risk. If interest rates are falling when fixed income assets and are to be re-invested, the rate of return will be less then desirable.
Exchange Rate Risk. This risk applies mostly to forgein stocks. Currency exchange rates are constantly changing so you could be buying on a strong dollar and selling on a weak dollar which impacts how much you get in U.S. dollars.
Market Risk. This risk affects all types of securities and most often is driven by changes in the economy.
Understanding these risks are important considerations as one evaluates where to allocate what percentage of what assets in the overall portfolio. How much in stocks? How much in bonds/fixed assets? In the stock portion, how much in income versus how much in growth stocks? In the bod portion, how much in long term versus short term? Then, in stock selection, how much do I risk in each stock? How do I manage that risk?
When I said above that my idea of risk was the risk of the price of my stock going down, while accurate, certainly fell way short of the actual risks. As I learned about these risks over the next 3 years of my vast experience, I have made several adjustments to my investment methods to mitigate the risks so I am not as exposed as I was. But, let there be no mistake, as much as you learn about risk you cannot eliminate it if you seek to be successful in your investments.
