1. Risk and Diversification: Introduction
  2. Risk and Diversification: What Is Risk?
  3. Risk and Diversification: Different Types of Risk
  4. Risk and Diversification: The Risk-Reward Tradeoff
  5. Risk and Diversification: Diversifying Your Portfolio
  6. Risk and Diversification: Conclusion

Every saving and investment product involves different risks and returns. Broadly speaking, investors are exposed to both systematic and unsystematic risks. Systematic risk is the risk inherent to the entire market or market segment, and it can affect a large number of assets. Also known as undiversifiable risk, volatility and market risk, systematic risk affects the overall market – not just a particular stock or industry. This type of risk is both unpredictable and impossible to avoid completely. Examples include interest rate changes, inflation, recessions and wars.

Unsystematic risk, on the other hand, risk affects a very small number of assets. Also called nonsystematic risk, specific risk, diversifiable risk and residual risk, this type of risk refers to the uncertainty inherent in a company or industry investment. Examples include a change in management, a product recall, a regulatory change that could drive down company sales and a new competitor in the marketplace with the potential to take away market share from a company in which you’re invested. It’s possible to mitigate unsystematic risks through diversification. (For related reading, see: The Importance of Diversification.)

In addition to the broad systematic and unsystematic risks, there are several specific types of risk, including:

Credit or Default Risk

Credit risk is the risk that a borrower will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is particularly concerning to investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal government, have the least amount of default risk and, as such, the lowest returns. Corporate bonds, on the other hand, tend to have the highest amount of default risk, but also higher interest rates. Bonds with a lower chance of default are considered investment grade, while bonds with higher chances are considered junk bonds. Investors can use bond rating agencies – such as Standard and Poor’s, Fitch and Moody's – to determine which bonds are investment-grade and which are junk. (See also: Corporate Bonds: An Introduction to Credit Risk.)

Country Risk

Country risk refers to the risk that a country won't be able to honor its financial commitments. When a country defaults on its obligations, it can harm the performance of all other financial instruments in that country – as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit. (See also: The Risks of Investing in Emerging Markets.)

Foreign-Exchange Risk

When investing in foreign countries, it’s important to consider the fact that currency exchange rates can change the price of the asset as well. Foreign exchange risk (or exchange rate risk) applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you live in the U.S. and invest in a Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the U.S. dollar. (For related reading, see: How to Avoid Exchange Rate Risk.)

Interest Rate Risk

Interest rate risk is the risk that an investment's value will change due to a change in the absolute level of interest rates, the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. This type of risk affects the value of bonds more directly than stocks and is a significant risk to all bondholders. As interest rates rise, bond prices fall – and vice versa. (For more, see: Managing Interest Rate Risk.)

Political Risk

Political risk is the risk an investment’s returns could suffer because of political instability or changes in a country. This type of risk can stem from a change in government, legislative bodies, other foreign policy makers or military control. Also known as geopolitical risk, the risk becomes more of a factor as an investment’s time horizon gets longer. (See also: What is Political Risk and What Can a Multinational Company do to Minimize Exposure?)

Market Risk

Market risk is the risk that an investment will face fluctuations and decline in value because of economic developments and other events that influence the entire market. Also referred to as systematic risk, this type of risk affects all securities in the same manner. Specific market risks can include interest rate risk, inflation risk, currency risk, liquidity risk, country risk and sociopolitical risk. While it’s impossible to completely avoid market risks, these risks can be mitigated to some extent by diversification – not just in terms of product or sector, but also by region and length of holdings. (For more, see: What are the Primary Sources of Market Risk?)

Risk and Diversification: The Risk-Reward Tradeoff
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