Understanding investment risk

“Risk”, to put it simply, is the probability that an investment’s return will be different from what is expected. The return could be higher or lower than expected but what matters is that the actual differential is unknown ahead of time. However, since the effects of lower-than-expected returns are obviously more problematic than higher-than-expected returns, “risk” in everyday language generally refers to the chance of lower returns.

Every investment carries some form of risk. However, good investors take steps to manage their risk. “Risk management” is the process of identifying, measuring, analyzing and actively managing risk in investment decisions, based on your investment plan and risk tolerance. “Risk tolerance” is the level of risk that an investor is willing to accept.

As an investor looking to manage the risk you’re exposed to, you’ll want to know what types of risk you’re carrying, and whether or not they’re within your control. In general, there are two main types of risk: systematic risk and non-systematic risk.

Systematic risk (also known as market risk or undiversifiable risk) is the risk that is inherent to investing and will change in value due to events that affect the entire market. Systematic risk can only be reduced through hedging.

The main subtypes of systematic risks are:

• Interest rate risk: The risk, (especially in bonds), that interest rates will rise or fall, changing the market value of the security in question.

• Equity risk: The risk, carried by equities, that the market price of those equities will rise or fall. As the supply and demand for certain shares changes, their value will change too.

• Currency risk: The risk, carried by investments in different currencies, that the exchange rate for those currencies will change. For example, if you own shares in American companies, but otherwise trade in Canadian funds, you will be exposed to the risk that the price of the US dollar changes relative to the Canadian dollar.

• Business Cycle Risk: Risk of owning risk assets (especially equities and commodities) during a recession cannot be diversified away.

Non-systematic risk (also known as specific risk or diversifiable risk) is the risk that an investment will change in value due to factors specific to that investment, not to the market in general. Non-systematic risk can be eliminated through diversification (see “Managing your risk” below).

Some examples of non-systematic risk include:

• Liquidity risk: The risk that you will not be able to sell your investment when you want to. If an investment takes any amount of time to sell, there is a risk that its value will change between when you choose to sell and when you’re actually able to.

• Concentration risk: The risk posed by a lack of diversity in your portfolio. The more concentrated your portfolio is – for example, the fewer companies or market sectors you are invested in – the more your returns will be affected by changes in those companies or sectors.

• Price risk: The risk that a particular investment will decline in value. For instance, investments in a car producer carry the price risk that a recall or employee strike will hurt that company’s performance and share value.

All investments carry some risk – it is up to you to manage how much risk your portfolio carries. There are two basic investment strategies that minimize risk: asset allocation and diversification.

Asset allocation: By building a portfolio containing a variety of asset classes (like equities, fixed income, , cash and cash equivalents), you decrease the effect that a change in returns in one asset class will have on your portfolio’s overall value.

Diversification: By diversifying within an asset class (for example: buying shares of different companies, in different regions, in different industries), you can protect yourself from non-systematic risk. Almost every investment plan encourages a fair amount of diversification – it’s always a good idea to avoid putting all your eggs in one basket. For example, by holding investments in multiple stocks, you decrease the risk posed by volatility in any one of them.