Investment Risk

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Investment Risk

What is investment risk?

In broad terms, investment risk is simply the risk that your investments will not perform as well as expected. Digging deeper, we can identify several more specific categories of investment risk. Although experts differ in the way they organize and explain these risks, the important thing is to recognize the basic factors at play, which make good sense when you think about them.

Whether your money is in stocks, bonds, or CDs, you are exposed to investment risk. Investment risk can’t be eliminated. But it can be managed—if you take time to make yourself aware of the different forms it can take.

Interest rate risk

With investments such as certificates of deposit (CDs) or US Treasury bonds, there is little risk to the value of your principal investment. Instead, you face interest rate risk: if the rate of inflation outpaces the rate of interest you are earning, you may not accumulate enough over time to keep pace with the increasing cost of living.

Systematic risk

With investments that aren’t FDIC- or NCUA-insured, such as stocks, bonds, and mutual funds, you face the risk that you might lose money, which can happen if the price falls and you sell for less than you paid to buy. History teaches us that there are several different ways you might lose money on an investment.

Systematic risk is also known as market risk and relates to factors that affect the overall economy and the financial markets. The key feature of systematic risk is that it affects all (or almost all) companies—even investments in financially sound companies are not immune. An unfavorable economic report—at home or abroad—or unexpected bump in unemployment, for example, are among the many factors that can cause the stock market to tumble. Persistent bad economic news or geo-political uncertainty can result in a longer-term downtick in market prices, generally.

The primary means of managing systematic risk is to allocate your investment portfolio among assets that tend to react differently to the same economic factors.

Nonsystematic risk

In contrast to systematic risk, nonsystematic risk affects a much smaller number of companies or investments. It is associated with investments in particular products, companies, or industry sectors, because it is based on factors specific to those investments.

Two prime examples of nonsystematic risk are management risk and credit risk:

• Management risk, also known as company risk, refers to the risk that bad management decisions, scandals or other missteps will hurt a company’s performance and, as a consequence, the value of investments in that company.
• Credit risk, also called default risk, is the possibility that a particular bond issuer won’t be able to pay interest as scheduled or repay the principal at maturity.

One way to manage nonsystematic risk is to spread your investment eggs among several baskets, diversifying your portfolio holdings within each major asset class—stock, bonds, and cash.