Chapter: 7 Understanding Risk

Section: 2 Types of Risks

In the context of stock investments, risk can be broadly divided into two major categories:

I. Systematic Risk
II. Unsystematic Risk - Diversifiable Risk

Systematic Risk
Systematic risk affects all the stocks in the market in general. In other words, the possibility exists that the financial markets will drop in value and create a ripple effect in your portfolio. While one cannot avoid this risk, by careful selection of stocks in various industries this risk can be minimized to a great extent. We will discuss risk reduction in a portfolio context in the next chapter.

The contributing factors to systematic risk include:

  • Interest Rate Risk: Interest rates are an important tool for the monetary policy of a country and hence have tremendous impact on economic growth, which is also reflected in stock prices. With lowering of interest rates, economic growth is triggered thus translating in higher earnings prospects for the companies. Also, risk free rate is an important input in any asset valuation model and a decrease in risk free interest rates reduces the discount rate for asset valuation thus increasing the Fair Market Value. An increase in interest rates can typically result in depressed stock prices across the board.

  • Currency Risk: Refers to possible fluctuations in currency exchange rates with currencies in rest of the world.

  • Inflationary Risk: The possibility that general price levels will go up in the market. We clearly want an interest rate that will not fall short of the inflation rate during the period of the investment. Otherwise we will not retain the purchasing power of our principal. For example, if we invest SR. 100,000 for a year at an interest rate of 8% and during this period the inflation rate turns out at 10%, we will need SR. 110,000 to purchase something that cost SR. 100,000 a year ago but we will only have SR. 108,000 from our investment i.e., we would have suffered a loss in our purchasing power by the end of the year. An increase in inflation would also push interest rates higher because the interest rates have two components: i) Real Interest Rate ii) Inflation.

  • Political Risk: The possible political vulnerabilities can affect the business and investment. Political risk, also called country risk, is the uncertainty of returns caused by the possibility of major change in the political or economic environment of a country. Individuals who invest in countries that have unstable political economic system must add a country risk premium when determining their required rate of return.

  • Recession Risk: The possibility of economic downturn.

Unsystematic Risk
Unsystematic or diversifiable risk is specific to an individual stock, firm or industry. The risk is inherent to the nature of business in the particular industry.

Examples of such risk include:

  • Default Risk: This is the risk that the issuer of a security, stock or bond, because of prolonged poor financial performance, can be forced to default on its commitments. In such a case, bond or share holders are paid only after the liquidation of assets. The point to remember is that businesses can run into trouble and a likelihood of default can emerge during the life of a business.

  • Business Risk: Business risk is the uncertainty of income flows caused by the nature of firm's business. The less certain the income flows of the firm, the less certain the income flows to the investors. Therefore, the investors will demand a risk premium that is based on the uncertainty caused by the basic business of the firm.

  • Liquidity Risk: Liquidity risk is uncertainty introduced by the secondary market for an investment. When an investor acquires an asset, he or she expects that the investment will mature (as with the bond) or that it will be saleable to someone else. In either case, the investor expects to be able to convert the security into cash and use the proceeds for current consumption or other investments. The more difficult it is to make this conversion, the greater the liquidity risk.

The good news about unsystematic risk is that it can be minimized or may be eliminated by building a diversified investment portfolio.