Macro Level Risks in an Investment Portfolio
Systematic and Unsystematic Risks
Systematic Risk: The risk within a system, in which a particular asset is associated and over which it has no control, and therefore cannot be diversified away.
"When the tide goes out, all the boats go down."
Examples of Systematic Risk:
- Inflation Risk - Inflation risk is the risk that the purchasing power of your investment returns will be reduced by increasing inflation.
- Reinvestment Risk - The potential that the investor will be unable to reinvest cash flows at a rate comparable to their current rate of return.
- Interest Rate Risk - Interest rate risk is the risk that changes in interest rates may reduce, or increase, the market value of a bond.
- Market Risk - All markets go through cycles, and market risk involves being on the downside of a cycle. Factors affecting market risk include political events, broad economic and social changes, and the mood and psychology of the investing public.
- Exchange Rate Risk - When U.S. investors buy assets denominated in foreign currencies, they face the risk of having both their principal and current income diminished by changes in the relative values of U.S. and foreign currencies.
Unsystematic Risk: The unique risk associated with owning a particular security. This risk can be mitigated through diversification.
Types of Unsystematic risks include:
- Business Risk - A firm’s ability to operate profitably and therefore is a major risk with common stocks.
- Financial Risk - Financial risk is directly related to the amount of debt a firm has (shown on its balance sheet).
- Credit Risk - Credit risk is the risk that a bond (or a preferred stock) will be downgraded due to excessive business risk and/or financial risk.
- Default Risk - Default risk is a higher degree of credit risk. When a firm cannot meet its obligations, it is in danger of defaulting.
- Liquidity Risk - The uncertainty of converting an investment into cash in a short period of time at, or near, the original principal invested.
- Event Risk - The possibility that a security will be affected by an unanticipated and damaging event.
- Marketability Risk - The risk that an asset cannot be converted to cash quickly at or near its current market price.
Total Risk = Systematic Risk + Unsytematic Risk