"Risk is uncertainty, and in uncertainty lies opportunity. Without uncertainty, there's little chance to profit."
Lorayne Fiorillo, author of
Financial Fitness in 45 Days
Types of general investment risk
Market Risk: This is when stock or bond prices drop and you appear to lose money on your investment. However, most losses are sustained over the short term of a year or less. As long as you don't sell, your investment will have the chance to recover from price declines and earn you a greater profit.
Inflation Risk: The
risk that the rising costs of inflation will outpace the growth of your investment
over time.
Company Risk:
This is the risk that the individual company in which you invest will fail
to perform as expected.
Credit Risk:
Specific to bonds, credit risk refers to the company or government's inability
to repay principal plus interest to the bondholder.
Maturity Risk:
Also specific to bonds, this is the risk that the value of a bond may change
from the time it is issued to when it matures. The longer the period to maturity,
the greater the potential for price fluctuation. That is why long-term bonds
generally offer a higher interest rate--to compensate for this greater risk.
Legislative Risk: Whatever
laws the government passes today may be extinct tomorrow. For example, the
long-term capital gains tax rate has been changed five times in the last 20
years, with the most recent cut at 20%. Factors such as tax deduction and
deferral should never be your sole reason for selecting an investment. These
perks are at the mercy of Congress.
Global Risk: It's always
a bigger risk to invest overseas than at home. Then again, it's generally
more rewarding to vacation in Europe than lounging around in the backyard.
Over 50% of the world's capital market opportunities exist outside of the
U.S., so a purely domestic strategy can severely limit your long-term earnings
potential.
Timing Risk: Timing risk
works two ways. First, you run the risk of investing a large sum of money
when share prices hit their peak. Second, there's the risk that you'll need
to access your money to pay for retirement or college expenses during a temporary
market setback--causing you to lose money on your investment.
Types of investment risks that are associated with a corporation
Cash flow risk
is the uncertainty regarding future cash flows.
Business risk is the uncertainty associated with operating cash flows of a business. There are different dimensions of business risk, namely sales risk and operating risk.
Financial risk is the uncertainty associated with how a firm finances its business (that is, debt vs. equity). We measure this with the degree of financial risk
Default risk is the uncertainty associated with the payment of required cash flows of a security (that is, the interest or principal of a bond) when promised.
Reinvestment rate risk is the uncertainty associated with the yield on the reinvestment of intermediate cash flows (e.g., the interest earned on a bond). The longer the maturity (all other features the same), the more the reinvestment rate risk. The greater the coupon rate (all other features the same), the more the reinvestment rate risk
Interest rate risk is the sensitivity of a security's price to the change in market yields. The longer the maturity of a bond (all other featues the same), the more the interest rate risk. The greater the coupon rate of a bond (all other features the same), the less the interest rate risk.
Currency risk is the uncertainty associated with changes in the relative value of currencies
Questions? Suggestions? Problems?
Types of risk
