Risk is simply the measurable possibility of either losing
value or not gaining value. In investment terms, risk is the uncertainty that
an investment will deliver its expected return. Before you can make suitable investment, you must understand the concept of risk, the
types of investment risk associated with various investment vehicles and the
amount of risk that you are willing to assume. In general, you must first
understand that no investment is without risk and that there is a trade-off
between returns and the amount of risk an investor is willing to assume in
order to reach his or her financial goals.
The following is a quick introduction on what risk is, the
different kinds, and how diversification can help to minimize risk.Business Risk
Business risk is the measure of risk associated with a
particular security. It is also known as unsystematic risk and refers to the
risk associated with a specific issuer of a security. Generally speaking, all
businesses in the same industry have similar types of business risk. But used
more specifically, business risk refers to the possibility that the issuer of a
stock or a bond may go bankrupt or be unable to pay the interest or principal
in the case of bonds. A common way to avoid unsystematic risk is to diversify -
that is, to buy mutual funds, which hold the securities of many different
companies.
Credit Risk
This refers to the possibility that a particular bond issuer
will not be able to make expected interest rate payments and/or principal
repayment. Typically, the higher the credit risk, the higher the interest rate
on the bond.
Interest Rate Risk
Interest rate risk is the possibility that a fixed-rate debt
instrument will decline in value as a result of a rise in interest rates.
Whenever investors buy securities that offer a fixed rate of return, they are
exposing themselves to interest rate risk. This is true for bonds and also for
preferred stocks.
Furthermore, understand the various factors that influence
interest rates, so that you can learn to anticipate their movements for your
benefit in the article, Trying to Predict Interest Rates.
Taxability Risk
This applies to municipal bond offerings, and refers to the
risk that a security that was issued with tax-exempt status could potentially
lose that status prior to maturity. Since municipal bonds carry a lower
interest rate than fully taxable bonds, the bond holders would end up with a
lower after-tax yield than originally planned.
Call Risk
Call risk is specific to bond issues and refers to the
possibility that a debt security will be called prior to maturity. Call risk
usually goes hand in hand with reinvestment risk, discussed below, because the
bondholder must find an investment that provides the same level of income for
equal risk. Call risk is most prevalent when interest rates are falling, as
companies trying to save money will usually redeem bond issues with higher
coupons and replace them on the bond market with issues with lower interest
rates. In a declining interest rate environment, the investor is usually forced
to take on more risk in order to replace the same income stream.
Inflationary Risk
Also known as purchasing power risk, inflationary risk is
the chance that the value of an asset or income will be eroded as inflation
shrinks the value of a country's currency. Put another way, it is the risk that
future inflation will cause the purchasing power of cash flow from an
investment to decline. The best way to fight this type of risk is through
appreciable investments, such as stocks or convertible bonds, which have a
growth component that stays ahead of inflation over the long term.
Liquidity Risk
Liquidity risk refers to the possibility that an investor
may not be able to buy or sell an investment as and when desired or in
sufficient quantities because opportunities are limited. A good example of
liquidity risk is selling real estate. In most cases, it will be difficult to
sell a property at any given moment should the need arise, unlike government
securities or blue chip stocks.
Market Risk
Market risk, also called systematic risk, is a risk that
will affect all securities in the same manner. In other words, it is caused by
some factor that cannot be controlled by diversification. This is an important
point to consider when you are recommending mutual funds, which are appealing
to investors in large part because they are a quick way to diversify. You must
always ask yourself what kind of diversification your client needs.
Reinvestment Risk
In a declining interest rate environment, bondholders who
have bonds coming due or being called face the difficult task of investing the
proceeds in bond issues with equal or greater interest rates than the redeemed
bonds. As a result, they are often forced to purchase securities that do not
provide the same level of income, unless they take on more credit or market
risk and buy bonds with lower credit ratings. This situation is known as
reinvestment risk: it is the risk that falling interest rates will lead to a
decline in cash flow from an investment when its principal and interest
payments are reinvested at lower rates.
Social/Political Risk
Risk associated with the possibility of nationalization,
unfavorable government action or social changes resulting in a loss of value is
called social or political risk.
Currency/Exchange Rate Risk
Currency or exchange rate risk is a form of risk that arises
from the change in price of one currency against another. The constant
fluctuations in the foreign currency in which an investment is denominated
vis-à-vis one's home currency may add risk to the value of a security.
Local investors will need to convert any profits from
foreign assets into Sing dollars. If the dollar is strong, the value of a
foreign stock or bond purchased on a foreign exchange will decline. This risk
is particularly augmented if the currency of one particular country drops
significantly and all of one's investments are in that country's foreign
assets. If the Sing dollar is weak, however,
the value of the local investor's foreign assets will rise.
Understandably, currency risk is greater for shorter term
investments, which do not have time to level off like longer term foreign
investments.
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