Investments have risks. One factor to manage in devising an investment strategy is to manage the various risks to the investment portfolio. One method to manage risks is to diversify the investments so the overall portfolio is less susceptible to any one risk.
- Business risk - The risk of the business invested in performing poorly. For example, the company losing business to competitors do to poor customer service.
- Currency risk - The risk of fluctuating exchange rates. For example, it is possible the investment itself (say in Japan) provides a positive return of 10% but because the Yen losses 10% of its value relative to your currency the return to you is 0.
- Inflation risk - The risk of loss of purchasing power due to the increase in costs over time due to rising prices. Used to capture potential loses not associated with a decrease in the absolute value of the investment but rather a decrease in purchasing power over time.
- Interest rate risk - the risk of rising interest rates for an income producing investment (such as a bond). Bond prices move inversely to interest rate moves. So if interest rates increase the price of bonds will fall. For short term bonds (under 3 years) the change in prices will be relatively minor compared to the change in price for a long term bond (10+ years).
- Liquidity risk - The risk associated with trying to close out a position. For stocks liquidity risk is normally small for small amounts of stocks. Real Estate or corporate bonds can have much more substantial liquidity risk which means you might have to accept a much lower price to attract a buyer in order to sell your investment when you wish to sell, or you will have to wait much longer to find a willing buyer.
- Market Risk (systemic risk) - The risks associated with the overall market. For example, if the overall market suffers a large decline that may well impact the return of a specific investment.
- Regulatory risk - The risk of a change in laws and regulation on the investment. For example, if the tax rate on dividends were to be treated as regular income (rather than given preferential status as they are now) the return to investors in investments paying dividends would decrease.
- Fraud risk - The risk of losing investments due to fraud, for example the company doctoring their books or an investment adviser taking assets. Some of these risks are partially covered by government insurance in the USA (SIPC, FDIC) but only in certain situations and to certain limits.
In the USA, the Pension Benefit Guaranty Corporation partially protects future pensioners from the business, investment return (if the assets the companies invest do not achieve a return sufficient to pay off the pension obligations) and fraud risks to their pensions.
Related terms:
- Nominal return - return measured without factoring in inflation
- Real return - measure of investment return factoring in inflation
- Risk adjusted return - a measure of investment return that factors in the risks taken to get the return.
Related Links
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