Types of Risk - Part 2

July 10, 2018

This is the second part of my series on risk. Last week I described the three types of systematic risk. This week, we will be talking about unsystematic risk.

Risk Level Graphic

I’m going to stick to the rule of threes when I also describe unsystematic risk. Micro risk only affects a specific company or investment—and can be controlled. Here are the three types described below:

  1. Business Risk
  2. Credit Risk
  3. Operational Risk

Business Risk

This is the risk of a business going out of business and is sometimes also referred to as specific risk, residual risk, diversifiable risk, etc. So, while market risk is basically risk that the whole market will go down, business risk is specific to one company and the likelihood that their stock will go down, due to poor management, or perhaps a big product recall because their product causes explosions, maybe. This type of risk can be addressed through diversification by owning many companies’ stocks and different sectors.

Credit Risk

Credit risk is the risk that a borrower won’t be able to pay back its debt. Most of the time this refers to bonds. With government bonds, the risk of default is lower than with a corporate bond, because typically the government can just raise taxes if they need more money to pay back their debt. Since a corporation is dependent on profits to pay back their debt obligations, they carry more credit risk. As an investor, you can use this higher risk to get a higher interest rate on bonds. There are rating agencies (such as Standard & Poors) that research bonds and give ratings to them in terms of credit quality. The higher the rating, the more credit-worthy a bond is. The bonds that have a lower chance of default are called investment grade, whereas the bonds with the higher chance of default are called junk bonds.

Included in credit risk is country risk and currency risk. Country risk is usually found in emerging markets, such as a third-world country that may run the risk of having a government mismanage funds and not be able to pay their debts. Currency risk applies to exchange rates; if you invest in a stock from Japan and the Yen depreciates in relation to the Dollar, this is currency risk, as even if the stock goes up, it still declined in value due to the Yen’s decline. The chart below from JPMorgan shows how the U.S. Dollar works with international returns. When a foreign currency weakens against the Dollar (Dollar strengthens), this decreases international returns. When the foreign currency strengthens against the Dollar (Dollar weakens), this will increase international returns.

Blog Graphic

Another thing I’m going to include under credit risk is liquidity risk. Liquidity risk is the risk that you won’t be able to sell your investment when you want to, and so as a result, you may have to accept a lower price, because you are desperate to sell. Or in some cases, you might not be able to sell it at all. Therefore, your investment may have value, but you can’t tap into that value because you can’t make it liquid, such as a piece of real estate.

Operational Risk

Operational risk refers to human errors. The investment fails due to breakdowns in policies and procedures. Some examples:

  • Company fraud
  • Incompetent management
  • Government regulations & sanctions, or geopolitical-think Brexit, the potential Trump tariffs
  • Outsourcing
  • IT failures-such as a cyber attack

This human element will vary from industry to industry, so again, diversification becomes very important.

All investments carry some form of risk; this is why we diversify. It is also important to keep in mind that just because an investment carries a higher risk, this doesn’t automatically mean you will receive a higher return in reward. There are no guarantees, so it is important to not only understand what you are investing in, but also what risks are associated with those investments. This is where a financial advisor can help!

Any opinions are those of Jill Carr and not necessarily those of RJFS or Raymond James. The information contained in this blog does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

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