Investment Risk and its types


Risk can be defined as the probability of failing to receive an expected return. Every investment involves uncertainties that make returns of investment risk prone. These uncertainties could be due to the political, economic and industry factors.

Types of Investment Risk

1. Systematic vs Unsystematic Risk

A risk could be systematic and unsystematic depends upon the source of it. Systematic risk is risk involved for the whole market, while unsystematic risk is specific to an industry or the company individually. The first three risk factors discussed below are systematic in nature and the rest are unsystematic. A political risk could affect the market as a whole or just a particular industry. Therefore, we must consider these two categories to understand the total risk. The following discussion introduces these terms. Dividing total risk into its two components, a general (market) component and a specific (issuer) component, we have systematic risk and non-systematic risk, which are additive:

Total risk = General risk + Specific risk

             = Market risk + Issuer risk

                                   = Systematic risk + Non-systematic risk

Systematic Risk: An investor can construct a diversified portfolio and eliminate part of the total risk, the diversifiable or non-market part. What is left is the non- diversifiable portion or the market risk. Variability in a security’s total returns that is directly associated with overall movements in the general market or economy is called systematic (market) risk. Practically, all securities have some systematic risk, it may be whether bonds or stocks because systematic risk directly encompasses interest rate, market, and inflation risks. The investor cannot escape this part of the risk because no matter how well he or she diversifies, the risk of the overall market cannot be avoided. For instance: If the stock market declines sharply, most stocks will be affected; if it rises strongly, most stocks will appreciate in value no matter about their performance for the past few weeks. Clearly, market risk is critical to all investors.

Non- systematic Risk: The variability in a security’s total returns not related to overall market variability is called the non- systematic (non-market or unsystematic) risk. This risk is unique to a particular security and is associated with such factors as business and financial risk as well as liquidity risk. Although all securities tend to have some non-systematic risk, it is generally connected with common stocks.

“Systematic (Market) Risk is attributable to broad macro factors affecting all securities. Non-systematic (Non-Market) Risk is attributable to factors unique to a security.”

Read more: What is a Stock Split? Why companies announce Stock Split?

Types systematic and unsystematic risk

1. Market Risk

The variation in security’s returns resulting from fluctuations in the aggregate market is known as market risk. All securities are exposed to market risk including recessions, wars, structural changes in the economy, tax law changes, even changes in consumer preferences. Market risk is sometimes used synonymously with systematic risk.

2. Interest Rate Risk

The variability in a security’s return resulting from changes in the level of interest rates is referred to as interest rate risk. Such changes generally affect securities inversely; that is, other things being equal, security prices move inversely to interest rates. The reason for this movement is tied up with the valuation of securities. Interest rate risk affects bonds more directly than common stocks and is a major risk faced by all bondholders. As interest rates change, bond prices change in the opposite direction.

3. Purchasing Power Risk

A factor affecting all securities is purchasing power risk also known as inflation risk. This is the chance that the purchasing power of invested dollars will decline. With uncertain inflation, the real (inflation-adjusted) return involves risk even if the nominal return is safe (e.g., a Treasury bond). This risk is related to interest rate risk, since interest rates generally rise as inflation increases, because lenders demand additional inflation premiums to compensate for the loss of purchasing power.

4. Regulation Risk

Some investments can be relatively attractive to other investments because of certain regulations or tax laws that give them an advantage of some kind. Municipal bonds, for example pay interest that is exempt from local, state and federal taxation. As a result of that special tax exemption, municipals can price bonds to yield a lower interest rate since the net after-tax yield may still make them attractive to investors. The risk of a regulatory change that could adversely affect the stature of an investment is a real danger.

5. Business Risk

The risk of doing business in a particular industry or environment is called business risk. For example, as one of the largest steel producers, U.S. Steel faces unique problems. Similarly, General Motors faces unique problems as a result of such developments as the global oil situation and Japanese imports.

6. Reinvestment Risk

The YTM (Yield to maturity) calculation assumes that the investor reinvests all coupons received from a bond at a rate equal to the computed YTM on that bond, thereby earning interest on interest over the life of the bond at the computed YTM rate. In effect, this calculation assumes that the reinvestment rate is the yield to maturity. If the investor spends the coupons, or reinvests them at a rate different from the assumed reinvestment rate of 10 percent, the realized yield that will actually be earned at the termination of the investment in the bond will differ from the promised YTM. And, in fact, coupons almost always will be reinvested at rates higher or lower than the computed YTM, resulting in a realized yield that differs from the promised yield. This gives rise to reinvestment rate risk. This interest-on-interest concept significantly affects the potential total dollar return. The exact impact is a function of coupon and time to maturity, with reinvestment becoming more important as either coupon or time to maturity, or both, rises. Specifically:

1. Holding everything else constant, the longer the maturity of a bond, the greater the reinvestment risk.

2. Holding everything else constant, the higher the coupon rate, the greater the dependence
of the total dollar return from the bond on the reinvestment of the coupon payments. Let’s look at realized yields under different assumed reinvestment rates for a 10 percent non-callable 20-year bond purchased at face value. If the reinvestment rate exactly equals the YTM of 10 percent, the investor would realize a 10 percent compound return when the bond is held to maturity, with $4,040 of the total dollar return from the bond attributable to interest on interest. At a 12 percent reinvestment rate, the investor would realize a 11.14 percent compound return, with almost 75 percent of the total return coming from interest on interest ($5,738/ $7,738). With no reinvestment of coupons (spending them as received), the investor would achieve only a 5.57 percent return. In all cases, the bond is held to maturity. Clearly, the reinvestment portion of the YTM concept is critical. In fact, for long-term bonds the interest-on-interest component of the total realized yield may account for more than three-fourths of the bond’s total dollar return.

Read more: What is Inflation and Deflation?

7. Bull-Bear Market Risk

This risk arises from the variability in the market returns resulting from alternating bull and bear market forces. When security index rises fairly consistently from a low point, called a trough, over a period of time, this upward trend is called a bull market. The bull market ends when the market index reaches a peak and starts a downward trend. The period during which the market declines to the next trough is called a bear market.

8. Management Risk

Management, all said and done, is made of people who are mortal, fallible and capable of making a mistake or a poor decision. Errors made the management can harm those who invested in their firms. Forecasting errors is difficult work and may not be the effort and, as a result, imparts a needlessly sceptical outlook. An agent-principal principle relationship exists when the shareholder owners delegate the day to day decision making authority to managers who are hired employees rather than substantial owners. This theory suggests that owners will work harder to maximize the value of the company than employees will. Various researches in the field indicate that investors can reduce their losses to difficult-to-analyse management errors by buying shares in those corporations in which the executives have significant equity investments.

9. Default Risk

Is that portion of an investment’s total risk that results from changes in the financial integrity of the investment? For example, when a company that issues securities moves either further away from bankruptcy or closer to it, these changes in the firm’s financial integrity will be reflected in the market price of its securities. The variability of return that investors experience as a result of changes in the creditworthiness of a firm in which they invested is their default risk. Almost all the losses suffered by investors as a result of default risk are not the result of actual defaults and/or bankruptcies. Investor losses from default risk usually result from security prices falling as the financial integrity of a corporation weakness-market prices of the troubled firm’s securities will already have declined to near zero. However, this is not always the case – ‘creative’ accounting practices in firms like ENRON, WorldCom, Arthur Anderson and Computer Associates may maintain quoted prices of stock even as the company’s net worth gets completely eroded. Thus, the bankruptcy losses would be only a small part of the total losses resulting from the process of financial deterioration.

10. International Risk

This includes both Country risk and Exchange Rate risk. All investors who invest internationally in today’s increasingly global investment arena face the prospect of uncertainty in the returns after they convert the foreign gains back to their own currency. Unlike the past when most U.S. investors ignored international investing alternatives, investors today must recognize and understand exchange rate risk, which can be defined as the variability in returns on securities caused by currency fluctuations. Exchange rate risk is sometimes called currency risk. For example, a U.S. investor who buys a German stock denominated in marks must ultimately convert the returns from this stock back to dollars. If the exchange rate has moved against the investor, losses from these exchange rate movements can partially or totally negate the original return earned. Obviously, U.S. investors who invest only in U.S. stocks on U.S. markets do not face this risk, but in today’s global environment where investors increasingly consider alternatives from other countries, this factor has become important. Currency risk affects international mutual funds, global mutual funds, closed-end single country funds, American Depository Receipts, foreign stocks, and foreign bonds. Country Risk Country risk, also referred to as political risk, is an important risk for investors today. With more investors investing internationally, both directly and indirectly, the political, and therefore economic, stability and viability of a country’s economy need to be considered. The United States has the lowest country risk, and other countries can be judged on a relative basis using the United States as a benchmark. Examples of countries that needed careful monitoring in the 1990s because of country risk included the former Soviet Union and Yugoslavia, China, Hong Kong, and South Africa.

Liquidity Risk

This Risk associated with the particular secondary market in which a security trades . An investment that can be bought or sold quickly and without significant price concession is considered liquid. The more uncertainty about the time element and the price concession, the greater the liquidity risk. A Treasury bill has little or no liquidity risk, whereas a small OTC stock may have substantial liquidity risk. It is that portion of an asset’s total variability of return which results from price discounts given or sales concessions paid in order to sell the asset without delay. Perfectly liquid assets are highly marketable and suffer no liquidation costs. Illiquid assets are not readily marketable and suffer liquidation costs. Illiquid assets are not readily marketable – either price discounts must be given or sales commissions must be paid, or both the costs must be incurred by the seller, in order to find a new investor for an illiquid asset. The more illiquid the asset is, the larger the price discounts or the commissions that must be paid to dispose of the assets.

Political Risk

It arises from the exploitation of a politically weak group for the benefit of a politically strong group, with the efforts of various groups to improve their relative positions increasing the variability of return from the affected assets. Regardless of whether the changes that cause political risk are sought by political or by economic interests, the resulting variability of return is called political risk if it is accomplished through legislative judicial or administrative branches of the government.

Domestic political risk arises from changes in environmental regulations, zoning requirements, fees, licenses, and most frequently taxes. Taxes could be both direct and indirect. Some types of securities and certain categories of investors enjoy a privileged tax status. International political risk takes the form of expropriation of non-residents assets, foreign exchange controls that won’t let foreign investors withdraw their funds, disadvantageous tax and tariff treatments, requirements that non-residents investors
give partial ownership to local residents, and un-reimbursed destruction of foreign owned assets by hostile residents of the foreign country.

Industry Risk

An industry may be viewed as group of companies that compete with each other to market a homogeneous product. Industry risk is that portion of an investment’s total variability of return caused by events that affect the products and firms that make up an industry. For example, commodity prices going up or down will effect all the commodity producers, though not equally. The stage of the industry’s life cycle, international tariffs and/or quotas on the products produced by an industry, product/industry related taxes (e.g. cigarettes), industry wide labour union problems, environmental restrictions, raw material availability, and similar factors interact with and affect all the firms in an industry simultaneously. As a result of these common features, the prices of the securities issued by the competing firms tend to rise and fall together. These risk factors do not make up an exhaustive list but are only representative of the major classifications involved. All the uncertainties taken together make up the total risk, or the total variability of return.

So, these are risks associated in investments of any kind. Investing the amount and monitoring for these risk make your investment safe and secure. Share with your friends. Leave your queries in comment section.

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A.Sulthan, Ph.D.,
Author and Assistant Professor in Finance, Ardent fan of Arsenal FC. Always believe "The only good is knowledge and the only evil is ignorance - Socrates"
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