Types of Stock Risk
Do any apply to your shares?
Stock risk varies in terms of the extent to which it affects the whole stock market or particular stocks. And investors, by their own behavior, may generate another set of investment risks.
Various types of investment risks are outline below ...
Systematic Risk or Market Risk
Systematic risk or market risk is the risk inherent in the whole market or market sector.
Sources of systematic risk include interest rates, recession and wars because they affect the entire market and cannot be avoided through diversification.
Systematic risk or market risk can be mitigated only by being hedged - a form of insurance guarding against unfavourable market movements.
Even a portfolio of well-diversified assets cannot escape this risk.
Unsystematic risk is stock risk that affects a very small number of assets or one stock. It is sometimes referred to as specific risk.
News that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be an unsystematic risk.
Financial risk is the risk that a company will not have adequate cash flow to meet financial obligations.
It is the additional stock risk a shareholder bears when a company uses debt in addition to equity financing.
Companies that issue more debt instruments would have higher stock risk than companies financed mostly or entirely by equity.
Sovereign risk is the risk that a country will not be able to honor its financial commitments. When a country defaults it can harm the performance of all other financial instruments in that country, as well as other countries.
Countries referred to as being emerging markets are considered to have greater sovereign risk.
Legislative Risk or Regulatory Risk
Legislative risk or regulatory risk is the stock risk that legislation by the government could significantly alter the business prospects of one or more companies, adversely affecting an investment holding in that company.
This may occur as a direct result of government action or by altering the demand patterns of the company's customers.
An example of an industry with high legislative risk is healthcare. Drug manufacturers and healthcare providers both must contend with many ongoing legislative issues related to government subsidies, insurance coverage and other customer payment issues.
Liquidity risk is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. This is usually reflected in a wide bid-ask spread (big difference between what the buyers are bidding and the sellers are asking), or large price movements.
Smaller companies shares tend to have lower liquidity as fewer investors are interested in buying them.
Political risk is the financial risk that the government of a country will suddenly change its policies. This is a major reason that third world countries lack foreign investment.
Mining companies often experience this type of risk when investing in countries with unstable political systems or uncertain legal systems. Mining company investments are commonly judged in terms of this type of risk.
Price risk is The risk that the value of a stock or portfolio of stocks will decline in the future. It's the risk that you will lose money due to a fall in the market price of a stock that you own.
Stock beta provides a measure of the volatility of stocks (the degree to which the stock price moves up or down), and may also be used to control the volatility of the overall portfolio.
Currency Risk or Exchange Rate Risk
Currency risk or exchange-rate risk is the risk that changes in currency rates may impact on the earnings of companies that generate overseas income.
This might be mitigated by undertaking currency hedging which is a form of insurance against unfavorable changes in currency rates. But this is an additional cost to the company.
Of course, changes in currency rates may also have a positive impact on foreign income if the change occurs in the right direction.
If for example exporters in your country are selling their products and receiving US dollars and the the currency in your country appreciates in relation to the US dollar, the exporters will receive more of your currency when the funds are converted.
Importers of US goods, on the other hand, will have to hand over more of your currency to buy goods in US dollars.
Transformation Strategy Risks
Transformation strategy risks or investment risks arise when a company embarks on a new venture which is designed to have a major bearing on the future direction of the company.
Significant capital or other investment expenditures may be involved - with uncertain outcomes.
Investor Created Risks
Besides the risks mentioned above that relate to companies and the stock market overall, investors may create their own set of risks.
Day trading risks are incurred on a regular basis by day traders, contracts-for-difference (CFD) traders and other high-risk investing types who speculate on the daily ups and downs of the stock market.
Investors who dabble in penny stock investing and hedge fund investing also expose themselves to a range of risks, some of which are mentioned above.
Given the range of stock risks investors and companies face over time, it is not hard to imagine that there is no such thing as risk-free stock investing, whether for the individual or the company.
This is why investors expect to receive a greater profit margin by investing in stocks rather than say cash or bonds.
Value investors are in a position to limit some risks, such as price risk and financial risk, by requiring a margin of safety in their buying strategy.
Many other risks mentioned above, while out of their control, can also be reduced by careful stock selection.
My buying strategy seeks to minimize risk by firstly avoiding particular classes of stocks, by careful consideration of financial ratios such as return on equity and debt to equity, and by requiring that the buying price of a stock is below its calculated intrinsic value.
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