It’s important to know and understand the various types of risks involved with investing in securities. So let’s look at some real life examples of these types of risks. First, let’s review risk in general, which is the chance that an investment’s actual return will be different than the expected return. Investors are mainly concerned with losing money when they think of risk. Now let’s look at some of the different types of risk present in investing.
There is MARKET risk. Market risk is the day-to-day potential for an investor to experience losses from fluctuations in securities prices. This risk cannot be diversified away. It is referred to as systemic risk. An example is what we went through recently. All the markets were weak because the whole system was weak; everything was losing value because the entire system was in peril. Just about everything lost value, stocks, corporate bonds, currencies, etc. So even a well diversified portfolio lost value due to overall market weakness.
Next, there is UNSYSTEMIC risk. Unsystemic risk is also known as specific risk or diversifiable risk. Think of it as Industry risk or Sector risk. A real life example is if you owned 20 stocks but they were all technology stocks. You might think you are diversified because you own 20 stocks, but you are not diversified sector wise. You are diversified in the tech sector but if the tech sector suffers a downturn in spending and profits, then more times than not, all your tech stocks will go down in value, not just a few. You could reduce, or diversify away, this industry specific risk by investing in stocks outside the technology sector.
Next there is COMPANY specific risk. This is one is a little easier to understand. Specific company risk is where you place too much of your investment in one specific company, and when that company does poorly then its stock will go down in value, even if the market is strong or if the sector is strong. A recent real life example would be in the financial services industry. This industry, or sector, was hit extremely hard, and the industry risk turned out to be great, but the company risk was even greater!
For instance, if you had invested all your money in the stock of Lehman Brothers, there is nothing left! But if you had diversified your investments between Lehman Brothers, JP Morgan, Goldman Sachs and Bank of America, you would not have lost everything. You would have lost money for sure due to sector risk, but you would not have lost all your money, due spreading the risk to various companies, not just one. You would have diversified away the company risk but not the sector or industry risk.
There is POLITICAL risk. Political risk is the risk that an investment’s returns could suffer as a result of political changes. The instability affecting investment returns could stem from a change in government, legislative bodies, other foreign policy makers, or military control. Political risk is also known as geopolitical risk.
Lastly, there is REINVESTMENT risk. This is the risk that future proceeds from an investment (for example, interest and dividends) will have to be reinvested at a lower interest rate. This risk is usually seen in the context of Bonds and/or CD’s. Reinvestment risk is especially evident during periods of falling interest rates where the coupon payments are reinvested at less than the yield to maturity of the current investment. This risk is particularly important to investors and retirees who are living off their current investments interest and dividends, only to see them be reduced over time due to those same reinvested proceeds producing lower future returns.
Stephen J. Cross is President and LPL Registered Principal of Cross Financial Strategies, LLC, located in Dallas, TX. Cross Financial Strategies, LLC provides unbiased, objective and customized financial advice for those who are accumulating, preserving, or distributing wealth. Mr. Cross earned the Chartered Retirement Planning CounselorSM designation offered through the College for Financial Planning®. He is host of the Financial Roundtable radio show as heard on KEOM 88.5 FM, Mesquite, TX. Mr. Cross can be reached at (214) 484-9476 and firstname.lastname@example.org. You can visit his website at www.crossfinancialstrategies.com. Securities and Advisory Services offered through LPL Financial, Member FINRA/SIPC