Risk

What types are there?

There are two major types of risk when investing: systematic and unsystematic. The first generally affects all assets equally and the second certain assets only. Diversification,while useful in reducing unsystematic risk, can do little for systematic risk.

An example of systematic risk would be if Russia hypothetically returned to communism. If this happened, most if not all assets in the Russian market would be equally affected. Conversely, if an individual company's employees went on strike for an extended period of time, this would hurt that specific company's stock and very few others. This is unsystematic risk.

Sometimes it is possible for both types of risk to be present. The best example of that would be just after Sept. 11, 2001. Most assets were hurt temporarily but certain industries were affected even more so, like airlines and lodging.

The three main kinds of systematic risk are inflation, interest rate and market. The first will erode your purchasing power if you're not careful, so it's important to invest in assets that will produce above the rate of inflation. The second is interest rate risk. There exists the real possibility that your five-year bond paying 5 percent interest will lose considerable market value should rates suddenly rise. Finally, there is market risk, where the markets drop dramatically and cause a panic sell-off, like what happened in 1987.

There are two main types of unsystematic risk: sector risk and credit risk. Sector risk is investing too heavily in any one sector of the economy, in essence putting all your eggs in one basket. Credit risk consists of two parts: the risk associated with the nature of the business and the risk derived from the financial leverage undertaken by the company. An example of business risk would be an online bookseller trying to compete directly with Amazon.com. Such an endeavor, while certainly possible, would likely be an uphill battle. Financial risk would be, for example, when a company doubles its level of debt in order to buy a business in an unrelated industry. While the acquisition could be successful, it would add substantial risk to the company stock.

Diversificationcan reduce the sector risk of a portfolio. By investing in companies across several sectors and industries, you reduce your exposure to any one in particular. On the other hand, prudent investment selection can reduce credit risk by screening for those stocks that have little debt and who are industry leaders. This is called a margin of safety.

Risk can't be eliminated entirely but with some careful planning it can be reduced significantly.

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