Different types of risk

Systematic risk (or market risk) is a type of risk that is related to the performance of the overall financial market. It happens when there are unpredictable factors such as environmental disasters, major political threats, or pandemics that damage the performance of most industries. One example is the 2008 global recession. During that time, most industries and companies performed poorly and the financial market collapsed, producing significantly lower than expected investment returns.

Unsystematic risk (or company / industry-related risk) is a type of risk that is specific to a company or industry-related problems that could cause a loss on your investment. These problems include regulatory changes, competition, low supply, product recall, or bad reputation which could produce lower investment returns on the affected company or industry. For example, let’s say you’ve been investing in oil companies in your region. However, after a year, the government creates a new regulation reducing oil extraction by 50%. As a result, oil companies in your region lose profitability, which could then produce a lower return on your investment.

 Foreign exchange risk is a type of risk where your investment could lose its overall return due to the changing exchange rates of the currencies involved. Suppose you want to invest $1,000 CAD in the US market and the exchange rate is $1 CAD to $0.80 USD. This gives you a total of $800 USD to invest in the US market. You then invest $800 USD in stocks and after 6 months, it grows to $1,200 USD.

Following this, you decide to sell and cash in your investment to CAD and in that time hypothetically the exchange rate is the same. This gives you a total return of $1,500 CAD (ignoring exchange fees and commissions) with a $500 profit from your original investment.

Now, suppose the US dollars weakens and the exchange rate is now $1 CAD to $1 USD. When you sell and cash in the same investment, the return will be $1,200 CAD with a total of $200 profit. Because of the change in the exchange rate, you produce a lower return compared to if the exchange rate is $1 CAD to 0.80 USD.

Inflation risk is a type of risk where the value of money you’re holding in an investment loses its actual value (in terms of buying power) despite its face value return. For example, let’s say you have an investment that returns 4% annually and that’s the rate of return you’re hoping to target and satisfied with. If we have a 2% inflation rate each year, your overall effective return would be 2%. While your investment has increased by 4%, your purchasing power has decreased by 2% because of inflation.

Business risk is a type of risk associated with the financial success of the business (or company) you’re investing in. When you invest in a business, you’re taking a chance that a business could make a profit or not, which could affect the return on your investment. For example, when you invest a stock from a company that’s just starting and small, there’s a higher risk that the company could be unprofitable because they’re still in the process of getting customers to buy their goods or services. If that happens, you may have a higher chance of getting a lower or no return on that stock.

Whereas if you invest a stock from a company that’s been operating for 15-20 years (a more established company), you may reduce the risk of getting lower than expected returns because the company already has customers buying their products or services. Other factors that affect business risk include competition from other companies, cost of raw materials, and supply and demand of products and services.

Liquidity risk is a risk when you’re unable to convert investments (or assets) into cash to meet short-term financial needs. Suppose you need $10,000 in 3 days because of a major repair for your home. If you have investments with a liquid asset such as a stock, you have the ability to quickly sell them and fund your home repair. In contrast, if you have invested in real estate, an illiquid asset, there’s going to be a higher chance you won’t be able to get $10,000 because real estate takes a longer time to sell.

Default risk is a risk where an investment could lose its value because of a default in credit obligation. When you lend money to a borrower, you’re taking a chance that the borrower won’t be able to repay their debt obligations whether in a form of monthly interest or principal payment. We see this when investing in bonds. Before you invest in bonds, you could check the credit rating of a bond issuer to see their trustworthiness or reliability in paying back their debt obligations. The higher the credit rating is, the less likely the issuer will default on their payments (and vice versa).

Interest rate risk happens when interest rates increase, adversely impacting the value of an investment. This typically happens when investing in bonds as there’s an inverse relationship between market interest rates and bond prices. For example, let’s say you invest in a corporate bond that issues a 5% coupon rate at a value of $1,000. After three years, the market interest rates go up and the bond issuer decides it needs more money to sustain the interest rate increase and expand operations. So they issue new bonds but this time they’re giving an 8% coupon rate at a value of $1,000. When this happens, your existing bond’s value declines (despite its face value) in the market due to the current bond having a higher rate. If you were to sell your existing bond before the maturity date, you may have to sell it at a discount because it’s competing with the other bond that has a higher coupon rate. Conversely, suppose the current interest rates go down in 3 years, the value of your existing bond goes up as it now has a higher rate than the newly issued ones.