Understanding Investment Risk Types

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Risk is a word that gets thrown around often, especially when referring to the stock market. Experts talk of the dangers of investing in the market and the dangers of not investing in the market. They talk about how you need to take on an acceptable level of risk for your tolerance and how you need to mitigate your desire for fantastic returns by taking on a reasonable level of risk. Risk sounds so risky! So, what are all of these risks and how can you mitigate them? That’s what I sought to finally understand and this is what I learned.

There are a lot of fancy names for risk but the bottom line is that understanding them gives you a better chance are being able to mitigate their effects. You can’t fully reduce risk but through proper diversification, you can reduce their effects on your total portfolio so there isn’t one silver bullet that can take you down.

First, let’s talk about the differences between systematic and unsystematic risk. Systematic risk also known as undiversifiable risk refers to risk that affects an entire market or market category, such as market risk. Short of investing abroad or hedging your bets, you can’t get away from market risk. Unsystematic risk is also known as specific risk and refers to events that affect a small number of stocks, such as the risk of a strike or poor management decisions. You can reduce unsystematic risk by properly diversifying your holdings.

Market Risk

Market risk refers to the risk you take on as a result of investing in a particular market, in my case it would be the United States. Market risk refers to the idea that if the overall market falls, perhaps in response to Fed actions on interest rates, rising costs of oil, etc., then your investment may slide along with every other stock.

To mitigate market risk, you have to diversify your holdings such that you’re not entirely committed to one particular market. An easy example is to diversify your holdings through the purchase of ADRs or emerging/developing/international stocks. In mitigating domestic market risk, you introduce several other risks such as the foreign country’s market risk (known as country risk) and currency risk (impact of the change in exchange rate between the dollar and the foreign currency). However, since you’re diversified, the effect of each of those risks is lowered.

Inflation Risk

Inflation risk refers to the risk you take by not investing your money, stock market brokers love this risk :). Inflation, which most rules of thumb peg at around 3-4% a year, erodes the purchasing power of your money every single year. If you don’t get 3-4% annual returns on your dollar, you’re effectively losing that money each and every year.

You mitigate inflation risk by investing your funds, but this naturally introduces a whole hosts of other risks. The only difference here is that inflation risk is a near certainty – inflation doesn’t roll the dice to see if she’ll erode your money this year, she always takes it. 🙂

Manager Risk

Manager risk, or management risk, refers specifically to the risk that your mutual fund, or the company you’ve invested in, will suffer as a result of ineffective, poor, or under-performing management. It essentially points to the fact that the company or fund may be sound but the management made bad decisions that cause the stock price or fund price to suffer.

This is difficult to mitigate outside of diversifying your assets because you often won’t see anything that could clue you in. Oftentimes, managers simply make bad decisions or bad bets and it’s nothing intentional. You don’t see many Enrons and, even if you did, there are no obvious signals warning you that something is foul. Simply do your research and be confident that the manager of the fund you’re interested in has a long, strong and solid history of performance.

A close relative of manager risk is active risk, which refers to the risk associated with a manager of a mutual fund trying to beat his or her benchmark. Active refers to actively trading, or active mutual fund (vs. passive index mutual fund), and it’s been shown that the more active the fund, the more divergent it will be with respect to returns vs. its benchmark. Sometimes you beat the benchmark, sometimes you don’t, that’s active risk.

All Other Risks

There are plenty of other risks out there with fancy names like Political Risk (effect of political instability or changes in a foreign country), Liquidity Risk (lack of demand for your investment might make it difficult to sell), Reinvestment Risk (you can’t reinvest your funds at the same rate, or at all), etc. but I felt that those big ones were the only ones worth focusing on at this point. There are a lot of risk terms out there that can get as specific or as general as you could ever possibly want, but understanding market, inflation, and manager risk is usually sufficient for most purposes.

{ 4 comments, please add your thoughts now! }

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4 Responses to “Understanding Investment Risk Types”

  1. Everyone should know their personal tolerance for risk after the last 8 months. The market has highlighted it very well.

    Another good thing to note is that inflation risk has increased greatly. The current inflation number of 4% is vastly understated, as it does not have the correct proportions of gas and food in the calculations. I have seen economists, who I respect greatly, suggest it might be around 7-8%. That’s a lot of risk.

    Good post.

  2. Tyler says:

    Being from Canada, I have been noticing that the largest risk for my portfolio over the past 5 years has been currency risk. The Canadian “loonie” has gotten much stronger and has increased the value of my Canadian holdings, but has crushed my US holdings.
    On a side note, I went to college and took out my student loans in Canadian dollars when the Canadian dollar was worth about $0.65 USD. When I paid my student loans back, the Canadian dollar was at $0.88 USD. How’s that for an expensive education! I got hosed.

  3. At the end of the day, there is only one real risk; the potential of the permanent loss of capital. You can invest all of your energy worrying about inflation, manager underperformance, reinvestment or “market” risk…but as you allocate capital, the only issue that the worlds best investors consider is “what is the risk of permanent capital impairment.”

  4. I will never understand why people will put there money in the bank and earn 2% a year from that. Worse then that some people just store their money and get no interest on it.

    Inflation is real. One of the worst risk is risking not to invest.

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