Understanding Investment Risk: Three Key Types To Know

Risk is an inherent part of investing, and understanding the different types of investment risks is crucial for making informed financial decisions. Investment risk can be broadly categorized into three types: systematic risk, unsystematic risk, and specific or idiosyncratic risk.

Systematic risk, also known as market risk, encompasses factors that impact the entire economic market or a large portion of it. This includes political risk, macroeconomic risk, and sociopolitical risk, among others. Unsystematic risk, on the other hand, is unique to a particular company, industry, or property. It includes factors such as management capabilities, financial structure, and consumer preferences.

Additionally, specific or idiosyncratic risk falls under unsystematic risk and affects only a specific industry or company. This could include changes in management, product recalls, regulatory changes, or new competitors.

Inflation risk

Investment risk can be broadly categorized into two types: systematic risk and unsystematic risk. Systematic risk affects the prices of all comparable investments and cannot be diversified away. Unsystematic risk, on the other hand, is unique to a firm, industry, or property and can be reduced or eliminated through diversification.

For example, consider an investor who buys a one-year bond with a $1,000 face value and a 5% nominal interest rate. Factoring in a 3% inflation rate, the investor's real rate of return on this bond is only 2%, resulting in a real value of the returned principal investment of just $970. This demonstrates how inflation can eat away at the purchasing power of an investment over time.

Bonds are considered the most vulnerable to inflation risk because they typically have fixed coupon rates that don't increase with inflation. As a result, if inflation rises significantly, the real returns for bond investors can even become negative, meaning their investment is losing them money.

To protect against inflation risk, investors can build an inflation premium into the interest rate or required rate of return (RoR) for an investment. Some securities, such as Treasury Inflation-Protected Securities (TIPS), also adjust their cash flows for inflation to maintain the purchasing power of returns. Additionally, assets like commodities, real estate, and well-diversified share portfolios have historically protected against the negative effects of inflation.

Credit risk

To assess credit risk, lenders and investors consider various factors related to the borrower's creditworthiness. These factors include the borrower's current debt load, income, credit history, capacity to repay, capital, loan conditions, and associated collateral. Credit rating agencies, such as Standard & Poor's, Fitch, and Moody's, play a crucial role in evaluating and quantifying credit risk for bonds. They assign letter-grade ratings, with AAA being the lowest credit risk and D indicating a current default.

While credit risk is a concern for bond investors, it is worth noting that the risk is generally lower compared to stocks. In the event of a company's bankruptcy, bondholders are prioritised for repayment before shareholders. As a result, bond investors are less likely to lose their entire investment in the case of a company's financial distress.

Overall, understanding and effectively managing credit risk is essential for investors and lenders to make informed decisions and mitigate potential losses. By considering the borrower's creditworthiness and seeking guidance from credit rating agencies, investors can better assess the level of credit risk associated with their investments.

Liquidity risk

Effective liquidity risk management involves ensuring the availability of sufficient cash, liquid assets, and accessible borrowing lines to meet both expected and unexpected liquidity needs. Maintaining a portfolio of high-quality liquid assets, employing rigorous cash flow forecasting, and diversifying funding sources are common strategies to manage liquidity risk.

For banks and financial institutions, managing liquidity risk is critical and is often regulated by frameworks that enforce liquidity standards, such as Basel III. These standards aim to ensure financial stability and protect depositors. Corporations also need to carefully manage liquidity risk by ensuring they have sufficient cash or access to credit to meet their operational and financial obligations.

Foreign investment risk

Foreign investments are typically divided into two categories: direct and indirect. Direct foreign investments are physical purchases made in a foreign country, such as plants, buildings, or equipment. Indirect foreign investments focus on acquiring positions in companies that might trade on a foreign stock exchange.

There are several types of risks associated with foreign investment. One is currency risk, also known as foreign exchange risk or exchange rate risk, which refers to currency fluctuations. An investment might be tied to the value of the foreign country's currency, and when that investment is sold and exchanged for the domestic currency, the exchange rate will determine the gain or loss.

Each country has its own central bank with its own monetary policy, and interest rates can fluctuate and impact the value of a particular asset. Political risks can also influence foreign investments, especially in autocratic nations. For example, in 2022, Russia imposed its own economic sanctions and measures on foreign investors in response to sanctions placed on the country by the US, EU, and other countries following Russia's invasion of Ukraine.

Other risks include a lack of information and transparency, as well as a potential lack of liquidity, which can make it difficult to sell the asset if needed.

Market risk

There are several types of market risk that investors should be aware of:

• Equity Risk: This is the risk associated with investing in stocks or shares. The market price of shares can fluctuate frequently due to changes in demand and supply, and investors may face a loss if the market price drops.
• Interest Rate Risk: Interest rate risk applies to debt investments, such as bonds. When interest rates rise, the market value of bonds tends to drop. This type of risk can also impact the value of real estate.
• Currency Risk: Currency risk arises when an investor owns foreign investments. For example, if the value of the US dollar decreases relative to the Canadian dollar, US stocks held by a Canadian investor will be worth less in their domestic currency.
• Commodity Risk: This type of risk is associated with investments in commodities such as crude oil or corn. Changes in commodity prices can impact the value of an investment, and investors may face losses if commodity prices move unexpectedly.

It is important to note that market risk is challenging to mitigate through portfolio diversification. Investors need to consider their risk tolerance and investment goals when deciding how to manage market risk. While it is challenging to eliminate market risk, investors can still aim to reduce its impact by considering strategies such as hedging or investing in assets that are less correlated with systematic risks.

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