You may have heard that the more risk you're willing to take on, the greater potential you have to earn high returns. However, there's a lot more to investment risk than this simplified statement. Aside from risk-free investments like Treasury bills, all investments have several types of risk factors, some broad-based, and some specific to each individual investment.
Here's what you need to know about the various types of investment risk so you can structure your portfolio accordingly.
Two main types of investment risk
When you invest, there are two main types of risk you need to be aware of: systematic, or non-diversifiable risk, and unsystematic, or diversifiable risk. In each of these two categories, there are several different risk factors.
These are risks that generally affect all investments of a certain asset class in the same way. Inflation is a good example -- if you invest in bonds, inflation generally drives down bond prices. Having a diverse portfolio of corporate, Treasury, and municipal bonds is unlikely to insulate you from this risk, which is why systematic risks are typically known as non-diversifiable risks.
In addition to inflation, some common types of systematic risk include the following:
- Market risk: Think of early 2009. Virtually the entire stock market was in free fall, even the companies with solid fundamentals. This is an example of market risk at work.
- Exchange rate risk: If you own foreign stocks from a certain market, currency fluctuations will impact all of your holdings.
- Interest rate risk: Bonds and other income-oriented investments are sensitive to interest rates. Rising interest rates generally put negative pressure on all bond investments.
To be clear, the "non-diversifiable" label refers to individual asset classes, not investments as a whole. For example, inflation is likely to put pressure on virtually all bond investments that aren't inflation protected. However, assets such as real estate tend to increase with inflation. The point is that you can't necessarily diversify your bond investments to mitigate inflation risk (unless you buy inflation-protected Treasury bonds), but you can reduce your inflation risk overall.
Unsystematic risks and what you can do about them
Unsystematic risks are also known as diversifiable risks because they can be easily mitigated with a well-diversified portfolio. For example, risks specific to a single stock are unsystematic risks. If a company has a terrible quarter, it will only directly affect that stock, not every stock in your portfolio.
Some common types of unsystematic risk include the following:
- Business risk: The example of a company reporting a bad quarter is a type of business risk and is diversifiable by investing in an assortment of different companies.
- Event risk: This is when something happens to a specific company that could impact a company's financial condition. Wells Fargo's infamous "fake accounts" scandal is a good example of this, as is United Continental's controversial handling of a passenger who refused to give up his seat.
- Financial risk: This describes risk related to the amount of leverage or debt that a business uses in its operations. Generally speaking, higher debt translates to greater risk of trouble if profits fall.
- Governmental risk: New regulations on an industry or specific company (or removal of regulations) are types of government risk. Tax consequences of investing also fall into this category.
- Default risk: A close cousin of financial risk, this is the risk that a company will be unable to meet its debt obligations.
- Country risk: If a company does business in foreign markets, it has risk related to these operations. For example, when the U.S. dollar strengthens against foreign currencies, companies with operations in those markets effectively lose revenue in terms of U.S. dollars.
As the name implies, these are risks that can be dealt with by crafting a properly diversified portfolio. For example, if bank stocks only make up 10% of your portfolio, the governmental risk of new banking regulations won't affect the other 90%. Or, if one of your stocks that makes up just 3% of your portfolio defaults on its debt, it will certainly be a drag on your portfolio, but the other 97% won't be affected.
High risk versus low risk
Generally speaking, the higher the risk you're willing to take on, the greater potential you have of high returns, as well as catastrophic losses. For example, if you have $10,000 and only invest in one stock, there's both the potential for outstanding returns if everything goes right and the potential to lose everything if that company goes belly-up.
On the other hand, a well-diversified portfolio of, say, 20 stocks isn't likely to double or triple within a year, but it also isn't likely to make you go broke. Of course, each individual stock or other investment has its own risk/reward profile that needs to be taken into consideration.
The bottom line: Investments are inherently risky, unless you're simply buying Treasury bills or putting your money in CDs. However, if you understand the various investment risks and how to deal with them, investing doesn't have to be very risky at all, especially from a long-term perspective.