Types of Investment Risk - Non-Systematic Risks

  1. Business Risk (non-systematic; equities, bonds): is the risk that the business in which one invests experiences downturns or even fails due to any number of factors. Examples would be the delay of a product rollout, key employee turnover, etc.
  2. Liquidity and Marketability Risk (unsystematic; equities, bonds, real estate, private equity): an investment is liquid if it can be converted into cash quickly with minimal effect upon its value. Liquid investments are typically more desirable in consequence and more marketable. Less liquid or illiquid investments may or may not be marketable and, as a result, are better suited for investors with little or no need for near term liquidity. Investments in real estate (not securitized), private equity funds, hedge funds, any private placement, thinly traded stocks, all manner of distressed securities and private ventures are subject to such risks. Suitability requirements often exist. (e.g. investor accreditation rules).
  3. Financial Risk (unsystematic; equities, bonds): refers to the effect that a firm's capital structure may have upon its profitability. For example, large amounts of debt can act as a double edged sword, both increasing a firm's return on its equity (ROE) and possibly reducing it as well. Also termed event risk, financial risk can result from an event that impacts the credit quality such as leveraged buyouts, mergers, acquisitions, share buybacks, decapitalizations, recapitalizations and restructurings.
  4. Political or Sovereign Risk (unsystematic; foreign equities and bonds): refers to the investment risks unique to the country in which they originate. The effect of political and economic risks upon investment are examples. A tax to discourage short-term profit taking, renationalization of an industry are types of such risk.
  5. Tax Risk (unsystematic; equities, bonds): is the risk of an unfavorable change in investment taxation brought about by legislation. Examples would be an increase in marginal income tax rates or capital gains tax rates.
  6. Investment Manager Risk (unsystematic; equity and fixed income managers of any strategy in any structure): investors in mutual funds, separately managed accounts and hedge/private equity funds face such risk. Examples would be a change in investment philosophy and process, turnover of key personnel or the acquisition of a privately held money manager by a larger concern where the latter could effect a change in the acquired manager's investment thesis.
  7. Credit (Default) Risk (unsystematic, fixed income): refers to the issuer's inability to make interest or principal payments when due. This is a type of business risk that directly impacts a company's creditworthiness. It is also a form of event risk as occurrences such as mergers, acquisitions and buyouts often add to a company's debt burden, increasing the likelihood of default risk.
  8. Call Risk (unsystematic, fixed income): this is the risk assumed by an investor in callable bonds or preferred stock. When the general level of interest rates decreases, issuers will often exercise their right to call their bond to reissue one at a lower interest rate. Beneficial to the issuer, callable bonds subject investors to reinvestment risk.
Planners need to be aware of all manner of risk to which their clients may be subject. This chapter has outlined the major types, if they can be reduced or eliminated by diversification and the investments most susceptible to them. The plethora of risks in investing only underscores the need for the investor and planner to codify risk/return objectives along with any unique constraints and pursue prudent diversification.
Practice Questions 1 - 4
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