Risk is omnipresent in our daily lives. There are definitely risks in the financial markets and we must understand what they are and if we can accept them. Below are the macro and micro risks, but the list is not exhaustive.
Market/Systematic Risk – Market or systematic risk cannot be diversified away as it is inherent in financial market, and it affects all securities. For example, a stock market crash is a form of systematic risk.
Inflationary Risk – If you do not invest in anything, you will assume inflationary risk. Goods and services will get expensive over time and your purchasing power will erode.
Political Risk – The economic well being of a country depends on the policies the government makes. Good governance and stability attract investment and foster business development. Despite so, no one can guarantee the government can continue to implement sound policies, or free of conflicts and social unrest in the future.
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Interest Rate Risk – The government may adjust interest rates and this will affect bonds, currency, deposits, properties and eventually businesses. For example, many people may take advantage of the low-interest rate environment to borrow money to buy properties. However, interest rate may rise in the future and result in higher installment payments.
Currency Risk – We know the value of currencies fluctuates every day. Price of an asset may rise or fall, not due to the demand and supply for the asset, but because of the changes in the strength of the currency. This is a reason why commodities producers like to hedge their products.
Idiosyncratic Risk – Idiosyncratic risk is more specific to a particular company or industry. For example, cooling measures for property prices affect the property stocks.
Managerial Risk – When you buy funds or ETFs, there is a risk where the manager can make mistakes or worse, scam the investors. When you leave money with a manager, you are under the mercy of his ability and integrity. Managerial risk applies to the management of a company too. The profitability of a business depends on how well the manager runs the business and whether he acts in the interest of the shareholders.
Transactional Risk – Transactions are not efficient. You may not be able to buy or sell at the desired price. The risk increases with larger orders.
Liquidity Risk – An asset may be liquid upon purchase. However, the demand for the asset may wane in the future and you may face difficulties in selling away the asset. You may need to price the asset very low to stir demands.
Credit Risk – This is the risk you assume when you lend money to another party. This can be in the form of bonds, mortgage-backed securities and IOUs, while the counter-parties can be government, companies and individuals. You may not get your money back in the event the counter-party becomes insolvent.
Counter-party Risk – This is an overlap with credit risk. However, I would scope this with market makers and insurers in mind. Some brokerage firms take the opposite side of the clients’ trades and may default their payout in the event they miscalculate the risks. Likewise, insurers may go bust due to a catastrophe where many clients make claims on their policies.