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What is portfolio risk exactly? | Wealth Management
Since the S&P 500 Index has gone from the low 700 in 2009 to its current level above 1,600, investors should be aware of their portfolio risk and have a downside strategy in place.
In the investment world, risk generally is associated with uncertainty. It refers to the possibility that you will lose some or all of your investment, or that an investment will yield less than its anticipated return. Simply stated, risk is the degree of probability that an investment will make or lose money.
Every investment carries some degree of risk because its returns are unpredictable. The more volatile an investment is - the more unpredictable its returns - the riskier it is generally considered to be.
Each investment is subject to all of the general risks associated with that type of investment. These risks are called “systematic risks” and are caused by conditions outside a company or industry that affect all similar types of companies. These conditions are generally difficult for the investment issuer to control, and individual securities selection within a given asset class can do relatively little to reduce those risks.
Risk also arises from factors and circumstances that are specific to a particular company, industry or class of investments. These are called “unsystematic” or “diversifiable” risks. As the name implies, unsystematic risks can be reduced by diversifying your investment portfolio. But diversification alone cannot guarantee a profit or ensure against the possibility of loss.
What are the types of systematic risk?
The stock market can be a great way to build wealth, but it can also plummet in little or no time at all. Specifically, market risk refers to the change in the price of securities caused by fluctuations in overall market conditions or in a specific sector of the market brought on by outside forces.
Interest rate risk
Interest rate risk is the risk of loss due to variation in the price of bonds (or preferred stock) because of changes in interest rates. When interest rates rise, bond prices fall; when interest rates go down, bond prices rise. The bond you bought when interest rates were low is worth less as interest rates increase because new bonds will generally offer the new, higher interest rates, thus reducing demand for older bonds.
Purchasing power, inflation risk or price level risk
Purchasing power risk, also referred to as inflation or price level risk, refers to the possibility that the return on your investments won't keep pace with increasing price levels. People who hold cash, savings accounts and bonds assume this kind of risk.
The danger is that their money may not grow enough over the years to allow them to achieve their financial goals.
Reinvestment rate risk
Reinvestment rate risk refers to the possibility that you will have to reinvest funds at a lower rate of return than the investment originally earned.
Exchange rate or currency risk
Exchange rate or currency risk arises because of fluctuating foreign exchange rates. These fluctuations may affect the value of foreign investments or profits when converting them into U.S. currency.
Political risk refers to possible changes in the government or legal environment. For example, taxes may rise, tariffs may be imposed or wages and prices may be controlled. All of these things could result in reducing a company's profits.
What are the types of unsystematic risk?
Business or industry risk refers to the risk associated with a particular company or industry. Business risk can be caused by changes in a company's sales due to operating problems, such as a strike, an unfavorable outcome of litigation or technical obsolescence. Industry-specific risks arise because some industries are inherently more uncertain than others.
Financial, credit or default risk
Financial or credit risk arises when a company incurs excessive debt. Put in accounting terms, financial risk is related to the company's debt-to-equity ratio. That means the company has a high fixed obligation, or interest rate, to pay each year. If the firm does not perform well, it may be unable to satisfy that obligation and pay bondholders or preferred stockholders.
Liquidity risk refers to the chance that an asset may not be easily sold or may not receive its full market value, especially if it must be sold on short notice.
Stephen Jackson is with Kirkland Wealth Management. He can be reached at 425-576-4035 or Sjackson@ifgrr.com.