The main factors that contribute to risk in investment portfolios can be broadly categorized into two key dimensions: systematic risk and unsystematic risk. Systematic risk, also known as market risk, refers to the risk that is inherent in the overall market or
economy and affects all investments to some extent. Unsystematic risk, on the other hand, is specific to individual assets or sectors and can be diversified away through proper portfolio construction.
1. Market Risk: This type of risk arises from macroeconomic factors such as
interest rate fluctuations, inflation, geopolitical events, and overall market conditions. It affects all investments in the market and cannot be eliminated through diversification. Market risk can be further broken down into the following components:
a.
Interest Rate Risk: Changes in interest rates can impact the value of fixed-income investments such as bonds. When interest rates rise,
bond prices tend to fall, leading to potential losses for bondholders.
b. Inflation Risk: Inflation erodes the
purchasing power of
money over time, reducing the real returns on investments. Investments that fail to keep pace with inflation can result in a loss of wealth.
c. Currency Risk: Investments denominated in foreign currencies are exposed to currency risk. Fluctuations in
exchange rates can affect the returns of these investments when converted back into the investor's home currency.
d. Market Volatility: Volatility refers to the magnitude and frequency of price fluctuations in the market. Higher volatility implies greater uncertainty and potential for larger price swings, increasing the overall risk of an investment portfolio.
2. Unsystematic Risk: This type of risk is specific to individual assets or sectors and can be diversified away by constructing a well-diversified portfolio. Unsystematic risk can be further classified into the following components:
a.
Business or Company Risk: This risk arises from factors specific to a particular company or business, such as management quality, competitive position, financial health, and operational efficiency. Adverse events like product recalls, lawsuits, or management scandals can significantly impact the value of individual stocks.
b. Sector or Industry Risk: Certain sectors or industries may face unique risks due to factors such as regulatory changes, technological disruptions, or shifts in consumer preferences. Concentrating investments in a single sector increases the exposure to sector-specific risks.
c.
Liquidity Risk: Liquidity risk refers to the possibility of not being able to buy or sell an investment quickly at a fair price. Investments with low trading volumes or limited market participants can be more susceptible to liquidity risk.
d. Event Risk: Event risk arises from unexpected events such as natural disasters, political instability, or terrorist attacks. These events can have a significant impact on financial markets and individual investments.
e. Credit Risk: Credit risk is associated with investments in fixed-income securities, particularly bonds. It refers to the possibility of the issuer defaulting on interest or
principal payments. Investments in lower-rated bonds carry higher credit risk.
f. Regulatory and Legal Risk: Changes in regulations or legal frameworks can affect the value and profitability of investments. Regulatory risks are particularly relevant in industries such as healthcare, energy, and finance.
Understanding and managing these various sources of risk is crucial for investors aiming to achieve an optimal balance between risk and return in their investment portfolios. By diversifying across different asset classes, sectors, and geographies, investors can mitigate unsystematic risk while still being exposed to systematic risk inherent in the market. Additionally, employing risk management techniques such as hedging, asset allocation, and regular portfolio rebalancing can help investors navigate the complexities of risk in investment portfolios.