In the roller-coaster that is life, there are a lot of risks. Some risks are necessary in order to progress anywhere meaningful. Other risks are unnecessary or the reward is not worth it, therefore they should be avoided.
Although there are some subjective aspects to risk like we talked about a couple weeks ago, there are also some objective aspects. Read our previous post, How Risky Are You?
Lets look at a common example of purchasing a home. When purchasing a house, there are a variety of risk; fire, flood, burglary, depreciation, liquidity, interest rate, etc.
Some of the risk can be mitigated or insured against, other risks are inherent with owning a home and cannot be avoided. These 2 variations of risk are called systematic and unsystematic risk.
As we go on we will look at these two types of risk in more detail and how they apply to the investment landscape.
Also known as undiversifiable risk or market risk, systematic risk is the inherit risk of being invested.
Systematic risk can be caused by recessions, periods of economic weakness, wars, changes in interest rates, fluctuations in currency and commodity prices, along with other big picture issues.
No matter how much diversification is done, systematic risk will always be present. Systematic risk is the minimum amount of risk that must be dealt with.
Below is a chart depicting systematic risk vs. unsystematic risk:
Lets look at a tangible example: Going for a walk. When you go for a walk you can prepare yourself. You can bring a compass, a water bottle, a jacket, comfortable shoes, etc. to make sure you have everything you would need.
However, you are still accepting some risk when you go on the walk. There is still the risk that you could get injured, encounter bad weather, get lost, etc. There are so many variables in life, and no matter how much planning is done, they still can’t all be controlled.
There are some investment products that offer virtually only systematic risk. These investment products usually offer lower returns, but for the extremely risk adverse investor, these might be the best option.
Also called diversifiable risk or non-market risk, is the risk associated with a particular company or industry.
Unsystematic risk can be generally defined as the uncertainty inherent in a company or industry investment. Unsystematic risk can be virtually nullified with a well diversified portfolio.
One of the most common types of unsystematic risk is concentration risk. Concentration risk happens when investments are all in the same company or industry, or industries that are very closely related.
Take for example, a farmer. Most of the farmer’s assets would be tied up is his farm and a large portion of that in the farm land. If the farmers off-farm investments were all in real-estate, his investments would be extremely concentrated.
This might seem self explanatory but the amount of people that are currently subject to high levels of concentration risk without realizing it, is staggering.
With the farmer, if the real-estate market goes down, there is a potential for large capital losses. Or if interest rates go up, it could become increasingly difficult to afford the payments on the properties.
Other Types of Risk
Within systematic and unsystematic risk, there are other specific types of risk:
Is the risk that the borrower will default on the loan. You should be most aware of credit risk when investing in infastructure or corporate bonds. Government bonds have the lowest credit risk compared to other interest bearing investment vehicles.
Is the risk that a country will not be able to pay off its debt obligations. When this happens, all of its stocks, bonds, and mutual funds are affected, as well as countries that have financial connections with it. This is more common in emerging economies.
Is the risk that a countries government will suddenly change its policies. This is more common in emerging economies.
This is the risk that when interest is generated, it will not be able to be reinvested at an equivalent interest rate as the principal was.
Interest Rate Risk
Is the risk that interest rates will change and affect the rate of return on your investments. One important rule for investing is: as interest rates go up, prices of bonds go down, and vice versa.
Foreign Exchange Risk
This risk applies to any investment that is denoted in any currency but your own. If you live in Canada and hold US stocks, there is a foreign exchange risk with holding those stocks. This is due to the fact that even though the investment might have done well, the price of each currency could have changed in relation to each other.
Is the Risk that the real return of an investment will be lower due to inflation. This is a huge concern for fixed income investments. Most fixed income investments offer returns between 1-3%. However, real return on these products is significantly lower or even negative once inflation is accounted for.
This is the risk that the value of your investment will decrease due to market risk factors. Market risk factors include a combination of interest rate risk, currency risk, credit risk, and the risk that a particular business might be overpriced/under priced for reasons of investor sentiment or a change in consumer trends.
This list of risks is not all-encompassing. There are other risks that can affect the value of your investments. Do some research and ask your advisor what risks your investments are exposed to. Make sure that you are not being exposed to undue amounts of unsystematic risk. If you are, it might be time to look for an advisor that is able to understand your particular situation and build a portfolio that fits into your risk tolerance.
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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy.