What Is Risk?

Risk is defined in financial terms as the chance that an outcome or investment's actual gains will
differ from an expected outcome or return. Risk includes the possibility of losing some or all of
an original investment.1

Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In

finance, standard deviation is a common metric associated with risk. Standard
deviation provides a measure of the volatility of asset prices in comparison to their historical
averages in a given time frame.

Overall, it is possible and prudent to manage investing risks by understanding the basics of risk
and how it is measured. Learning the risks that can apply to different scenarios and some of the
ways to manage them holistically will help all types of investors and business managers to
avoid unnecessary and costly losses.

Types of Risks

Every saving and investment action involves different risks and returns. In general, financial
theory classifies investment risks affecting asset values into two categories: systematic
risk and unsystematic risk. Broadly speaking, investors are exposed to both systematic and
unsystematic risks.

Systematic risks, also known as market risks, are risks that can affect an entire economic market
overall or a large percentage of the total market. Market risk is the risk of losing investments
due to factors, such as political risk and macroeconomic risk, that affect the performance of the
overall market. Market risk cannot be easily mitigated through portfolio diversification. Other
common types of systematic risk can include interest rate risk, inflation risk, currency risk,
liquidity risk, country risk, and sociopolitical risk.

Unsystematic risk, also known as specific risk or idiosyncratic risk, is a category of risk that
only affects an industry or a particular company. Unsystematic risk is the risk of losing an
investment due to company or industry-specific hazard. 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. Investors often use diversification to manage unsystematic risk by investing in a
variety of assets.

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

Business Risk
Business risk refers to the basic viability of a business—the question of whether a company will
be able to make sufficient sales and generate sufficient revenues to cover its operational
expenses and turn a profit. While financial risk is concerned with the costs of financing,
business risk is concerned with all the other expenses a business must cover to remain
operational and functioning.9 These expenses include salaries, production costs, facility rent,
office, and administrative expenses. The level of a company's business risk is influenced by
factors such as the cost of goods, profit margins, competition, and the overall level of demand
for the products or services that it sells.

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.9 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 high yield or 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.

Country Risk
Country risk refers to the risk that a country won't be able to honor its financial
commitments.9 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.

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.9 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.

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.9 As interest rates rise, bond prices in the
secondary market fall—and vice versa.

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.9 Also known as geopolitical risk, the
risk becomes more of a factor as an investment’s time horizon gets longer.
Counterparty Risk
Counterparty risk is the likelihood or probability that one of those involved in a transaction
might default on its contractual obligation. Counterparty risk can exist in credit, investment, and
trading transactions, especially for those occurring in over-the-counter (OTC) markets.
Financial investment products such as stocks, options, bonds, and derivatives carry counterparty
risk.

Liquidity Risk

Liquidity risk is associated with an investor’s ability to transact their investment for
cash. Typically, investors will require some premium for illiquid assets which compensates
Risk vs. Reward

The risk-return tradeoff

is the balance between the desire for the lowest possible risk and the highest possible returns.
In general, low levels of risk are associated with low potential returns and high levels of risk are
associated with high potential returns. Each investor must decide how much risk they’re willing
and able to accept for a desired return. This will be based on factors such as age, income,
investment goals, liquidity needs, time horizon, and personality.

The following chart shows a visual representation of the risk/return tradeoff for investing,
where a higher standard deviation means a higher level or risk—as well as a higher potential
return.

It’s important to keep in mind that higher risk doesn’t automatically equate to higher returns.
The risk-return tradeoff only indicates that higher risk investments have the possibility of higher
returns—but there are no guarantees. On the lower-risk side of the spectrum is the risk-free rate
of return—the theoretical rate of return of an investment with zero risk. It represents the interest
you would expect from an absolutely risk-free investment over a specific period of time. In
theory, the risk-free rate of return is the minimum return you would expect for any investment
because you wouldn’t accept additional risk unless the potential rate of return is greater than the
risk-free rate. them for holding securities over time that cannot be easily liquidated.

Risk and Diversification

The most basic—and effective—strategy for minimizing risk is diversification. Diversification

is based heavily on the concepts of correlation and risk. A well-diversified portfolio will consist
of different types of securities from diverse industries that have varying degrees of risk and
correlation with each other’s returns.

While most investment professionals agree that diversification can’t guarantee against a loss, it
is the most important component to helping an investor reach long-range financial goals, while
minimizing risk.

There are several ways to plan for and ensure adequate diversification including:
 1. Spread your portfolio among many different investment vehicles—including cash,
stocks, bonds, mutual funds, ETFs and other funds. Look for assets whose returns
haven’t historically moved in the same direction and to the same degree. That way, if
part of your portfolio is declining, the rest may still be growing.
2. Stay diversified within each type of investment. Include securities that vary
by sector, industry, region, and market capitalization. It’s also a good idea to mix styles
too, such as growth, income, and value. The same goes for bonds: consider varying
maturities and credit qualities.
3. Include securities that vary in risk. You're not restricted to picking only blue-chip stocks.
In fact, the opposite is true. Picking different investments with different rates of return
will ensure that large gains offset losses in other areas.

Keep in mind that portfolio diversification is not a one-time task. Investors and businesses
perform regular “check-ups” or rebalancing to make sure their portfolios have a risk level that’s
consistent with their financial strategy and goals.