There are basically two categories of financial risk: The first is known as Systematic Risk.
Systematic risk influences a large amount of investments across an extensive spectrum. The financial crisis of 2008 would have been a good example. Virtually, every asset was impacted adversely. This type of risk is nearly impossible to guard against. In other words, sometimes lightning strikes.
The second is known as Unsystematic Risk, also commonly called “Specific Risk.”
This is the kind of risk that impacts a smaller amount of investments across a slender spectrum. An example of this would have been a respectable company using dubious financial practices (think Enron). Proper diversification is the important thing to providing protection from this kind of risk.
Now let’s explain in greater detail the specific kinds of Unsystematic Risk that exist in the world of investing.
This is the kind of risk that you might be most familiar with. It’s simply the standard fluctuations in the buying price of an investment. It’s most apparent in stock-related investments.
To put it simply, it is the chance that the investment will decline in value, due to market forces. This is also sometimes known as volatility, that is actually the way of measuring market risk. These movements in markets are what provide the capability for an investor to create money.
This is also known as default risk. This occurs each time a person or entity (company/government agency, etc.) is unable to pay what they owe on the debt. It may be either the principal or the interest. Corporate bonds are apt to have a greater risk of defaulting but tend to cover higher rates of return in an endeavor to compensate. Government bonds are apt to have lower default rates but pay a lower rate of return. If a relationship is known as (by a standing agency) to really have a relatively low likelihood of risk of default, then it is known as investment grade. Conversely, If a relationship is known as (by a standing agency) to really have a relatively high likelihood of default, then it is known as a junk bond. This is somewhat of a misnomer, since “junk bonds” could be a solid addition to an investment portfolio and can mitigate other kinds of risk.
This refers to the chance that’s inherent each time a country cannot meet its financial commitments (think Greece). Each time a country defaults on its obligations, the impact is usually that of a cascading nature. Which means not only will the bonds of the country be affected but also other financial assets within the country, such as the overall stock market. Furthermore, other countries or companies that business with the defaulting company may also be impacted.
Investing in foreign countries provides many advantages, especially when it comes to diversification. When you invest in assets or debt of foreign countries, remember that the currency exchange rates can transform the buying price of the asset or debt. So, even although asset increases in value once you exchange it for your house currency, you might suffer a loss. The converse can be true: the asset could go down, but once you transfer it into your house currency, you might like to realize a gain.
Interest Rate Risk
This refers to the chance each time a change in interest rates affects the value of a resource or debt instrument. Typically, the chance relates to bonds in a far more direct fashion than it will to stocks. However, stocks, especially preferred, convertible and high dividend ones, may also be affected. With all things being equal, as interest rates increase, the value of the bond will decrease.
This refers to the chance occurring when the policies of a country change, especially when it happens in a random manner. For example, if your company is selling in country ABC and that country radically changes its tax laws and becomes business unfriendly, companies that business because country can be adversely affected.
1) Risk cannot be avoided and needs to be understood.
2) Through proper planning and execution, you are able to mitigate risk and benefit from it.
3) Your goal would be to minimize risk and maximize rewards.
4) Although the marketplace rewards risk-taking, that will not imply that simply because an investment is high-risk it will undoubtedly be high-reward. It always has been and always would have been a trade off.
5) Review all of your investments to make sure you understand which kind of risks you have.