Risk is a funny word. It's one of those things that can mean anything you want it to. At its most basic, you can think of it as the possibility that something unwanted will happen. The term has a negative connotation, but it's also what drives returns - the reason the stock market is a source of growth for investors is because you are compensated for the possibility of losing money. When it comes to your financial life, discussions of risk revolve around trying to predict what your reaction will be if an investment you own, or your entire portfolio, loses a lot of money really quickly. What would you do? Would you sell everything to stop the bleeding? Ignore it and wait out the volatility? Buy more of the investments you already own?
The thing is that portfolios, and certainly individual stocks and bonds, will undoubtedly lose value at some point. That's why we 1) diversify and 2) invest for the long term. I talk everyone's ear off about the specific reasons why those are two key aspects underpinning my investment philosophy, so if I haven't talked yours off yet, feel free to avail yourself of the privilege. But this post is about the different kinds of risk to which we're exposed as investors, and it's not as simple as just something losing value. There can be lots of different reasons why and I think it's important to understand them. So here's a rundown.
First, it's helpful to think of risk in two broad categories:
Systematic risk is undiversifiable. Its other name is market risk. These risks affect the whole market, or a big part of it, so you can't eliminate it by just buying a lot of different things. If you hold a truly diversified portfolio, this can be thought of as the amount of risk you've taken over the risk-free rate. Some examples:
- Interest rate risk: the possibility that rates will increase, causing the price of bonds to decline. But you don't own bonds, you say? Maybe. But companies borrow to finance their projects, and if interest rates increase, they have to pay more to do that.
- Inflation risk: when prices go up, everyone pays more. But also: it erodes your purchasing power in the long term, meaning you will not be able to buy as much for the same amount of money in the future. So investment returns have to exceed inflation consistently.
- Economic risk: recessions and depressions can have a broad contagion effect on the markets in general, even if the specific company in question is otherwise sound
- Reinvestment risk: the inverse of interest rate risk, this is the possibility that if rates fall, you will not be able to reinvest at the same rate you've been earning, and your money will yield a lower return. Again, even if you don't own individual bonds, the companies you own in your portfolio (think banks here) are subject to this risk.
- Regulatory/political risk: the likelihood that the greater environment in which economies operate shifts suddenly, with new and unforeseen laws and regimes to contend with.
Unsystematic, or specific, risk relates to a particular company or sector, and owning a broad representation of the overall market reduces the impact that these risk factors have on your portfolio. There are formulas and methods that seek to quantify the extent to which two securities are correlated (meaning, how much they move together). Just a few examples:
- Default risk: the risk that the borrower defaults on a debt payment. The US government is considered free of default risk (you will always get your money back when you buy US Treasury securities - the government will simply print more money if they have to!) and for that reason, the interest rate on these securities is used as the basis for pricing everything else. The rate on these represents the possibility of losing money due to all the other factors listed below. It's a misnomer, but this is known as the risk-free rate: really that just means it's free of default risk.
- Liquidity Risk: the possibility that you won't be able to find a buyer for your asset as quickly as you need. Think of the difference between owning a house, and owning Apple stock. You will have a buyer for your shares as quickly as you make them available for sale, as long as you're content with the current market price: buyers and sellers find each other very easily, the transaction occurs pretty much instantaneously, costs are low, and you get your money quickly. On the other hand, even if you are willing to sell your house for $100, it will probably take a little while to find a buyer (and the transaction will take a long time besides) due to the illiquidity of the market. Thinly traded stocks and alternative investments like commodities and hedge funds are other examples of investments that might take a long time to sell.
- Management risk: the risk that the leaders of the company won't be able to execute the strategy, will leave, or will underperform in some way.
You can certainly imagine some other risks that a particular company or asset runs, that are specific to the circumstances. In addition, you can also imagine that when you hold a lot of the same type of asset, what affects one will affect the rest. And really, if an asset price decreases, there might be a definitive reason and there might not be. Sometimes an asset loses value and we don't know why! But the above list will help you think about the forces at play in your portfolio, and consider the importance of diversification as well as the return you expect to receive for the possibility of losing your money.