Most people when asked what investment risk is typically respond with the phrase "losing money." There are many more layers than just that simple answer and knowing how to respond to the different kinds of risk can help you be more knowledgeable about your investments. Her's a little multiple choice quiz for some fun. (Answers are at the of this article.)
- How do you define investment risk?
A. Losing money
B. The probability that the actual return of an investment will differ from its expected return
C. The variability of returns from an investment compared to the average return of that investment
D. All of the above
- The various types fo risk are divided into which of these categories? (Choose all that apply.)
- What is purchasing power risk called?
A. OMG risk
B. Inflation risk
- Which of the following are NOT a type of investment risk?
A. Interest rate
- Liquidity risk refers to:
A. Uncertainty of converting an investment into cash
B. How many bubbles there are
C. The Atlantic Ocean
- Business risk can be eliminated in a company?
ANSWERS: How did you do?
2. A & B (Systematic and Unsystematic risk)
Systematic risk affects the prices of all comparable investments. If an economic or political factor comes into play, it can impact all securities to varying degrees (similar to "a-rising-tied-lifts-all-boats"). If you invest, you will be subject to systematic risk and cannot diversify away systematic risk. Unsystematic risk (Also referred to as diversifiable risk), can be potentially offset since—to a large extent—the investment risk can be partially reduced or eliminated through diversification. Examples of unsystematic risk include business risk, financial risk, default risk, and liquidity (or marketability) risk.
Purchasing power is also know as inflation risk as it erodes the ability to purchase goods and services. It's important that an investment portfolio earn more than the long-term rate of inflation. Rarely during short-term periods of rapidly increasing inflation will investments keep up as we are experiencing now.
Physical risk. interest rate risk is caused by the fluctuations in the general level of interest rates resulting in the changing market value of bonds. Generally, when interest rates for new bonds rise, market values for lower-rate bonds fall. When interest rates for new bonds fall, market values for higher-rate bonds tend to increase. Market risk arises from the changes in the market price of securities. Most securities in a similar "market" like U.S. Large Cap Stocks, tend to move in the same direction and can't easily be diversified away. However, reducing the impact of market risk can be achieved by investing in many different markets, such as foreign companies, real estate, and alternative investments.
If you can't easily and quickly sell an investment in a short period of time—at or near the quoted market price—you experience liquidity/marketability risk.
The risk that a business will operate profitably can't be eliminated, so buying shares of an individual company subjects you to that risk. However, this risk can be greatly reduced by buying into a diversified group of companies (stocks) of different industries, geographic regions, and size. Additionally, risk can be reduced by investing in mutual funds which own a broad range of company stocks.