In general, one can distinguish between two types of risk – the systematic risk and the unsystematic risk. A systematic risk is involved in most investments. For example, a significant political event could affect multiple investments in your portfolio. It is almost impossible to protect yourself from this risk.
The unsystematic risk is also called “specific risk”. This type of risk affects only a few investments. An example of this is bad news that has a negative impact on the stock of a particular company – such as a sudden strike.
Risk diversification is the only way to protect yourself from this risk. There are many special risk forms that apply especially to stocks and investments.
Credit or default risk
The credit risk (or default risk) is the risk that a company or individual will not be able to meet financial demands or pay the interest associated with these claims. This type of risk particularly affects investors who have bonds in their portfolios.
Government bonds, and Bunds in particular, have the lowest default risk and the lowest returns, while corporate bonds tend to carry the highest risk of default, but also bring a high return. Low-risk bonds are generally safe investments, while high-risk bonds are considered scrap bonds.
Rating agencies such as Moody’s regularly re-classify countries’ sovereign credit ratings and thus the security of government bonds, so investors can better assess the risks they are taking.
Country risk: The country-specific default risk
Country risk is the likelihood that a country will not be able to meet its financial obligations. If a country does not pay its debts, it has a negative impact not only on all the financial instruments emanating from that country, but also on the financial markets of all other countries with which the country has a close relationship.
Country risk concerns equities, bonds, mutual funds, options and futures issued by a particular country. This type of risk is most prevalent in emerging markets and, not least, plays a very important role in countries whose public purse is in the black.
Risk and diversification: The exchange rate risk
When investing in non-US countries, you must expect current exchange rates to affect the price of investment products. The exchange rate risk affects all financial instruments that do not work with your home currency.
Interest rate and political risk
The interest rate risk, as the name implies, is the risk that the value of an investment will decrease as a result of the change in an interest rate. This risk affects bonds more frequently than equities.
Political risk is the financial risk associated with sudden changes in a country’s policy. It is the main reason that developing countries have relatively few foreign investors.
The market risk also known as the volatility
This is the most common type of risk. Market risk is also called “volatility” and represents the daily fluctuations in stock prices . Volatility mainly affects stocks and options. The price fluctuations do not indicate in which direction the stock market is developing. Rather, they are the direct consequence of certain previous market developments.
Volatility is a good risk indicator because it describes the “temperament” or behavior of a stock. However, one can not derive the reasons for this behavior from the market risk. As market volatility is one of the reasons why you can make money on the stock market, volatility is important for the return.
The more unstable the stock price is, the greater the likelihood that a stock will soon go through a dramatic trend in a particular direction. As you can see, investors in the stock market have many different risks to consider and factor in.