When considering an investment, a fundamental concept should be clear; the relation between risk and return.
The higher the risk of investments, the greater the possibility of a higher return materializes; the lower the risk of an investment, the lower the potential return.
But how is risk calculated, and what are the factors that one should consider? When making an investment in any type of security, the investor needs to consider various risk principles, those inherent in the purchased security, and those affected by external factors.
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 render unable to pay the interest or principal in the case of bonds. A common way to avoid unsystematic risk is to diversify your portfolio.
Economic risk is the chance that macroeconomic conditions like exchange rates, government regulation, or political stability will affect an investment.
Economic risk can be mitigated by selecting international securities since they provide diversification, often investing in a variety of countries, instruments, currencies, or international industries.
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. Therefore, investors should consider that the longer the duration of the investment, the more the impact of interest rate fluctuation on the price of the security held.
EXCHANGE RATE RISK
Exchange rate risk (or Currency 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. This type of risk is greater for shorter term investments, which do not have time to level off like longer term foreign investments.
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 of limited supply opportunities.
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 highly rated government securities which are readily traded on markets.
Time horizon of investments is a major consideration for every investor.
Another important factor an investor needs to be aware of is time horizon; the length of time an investment is held until it is liquidated. The longer the time horizon, the riskier the investment becomes, and vice versa. For that reason, it is important for the investor to specify the time horizon of his investment before accessing any market.
However, not all risks can be calculated. Do you remember the 2008 Global Financial Crisis?
Systemic risk is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy.
This type of risk cannot be alleviated or averted. The biggest example of Systemic Risk is the 2008 financial crisis.