Risk & Types of Risk

A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk.

A company's risk is composed of financial risk, which is linked to debt, and risk, which is often linked to economic climate. If a company is entirely financed by equity, it would pose almost no financial risk, but, it would be susceptible to business risk or changes in the overall economic climate.

Let's take a look at the two basic types of risk: 
Systematic Risk - Systematic risk influences a large number of assets. A significant political event, for example, could affect several of the assets in your portfolio. It is virtually impossible to protect yourself against this type of risk. 
Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of risk affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect yourself from unsystematic risk.

The risk that is specific to an industry or firm. Examples of Unsystematic risk include losses caused by labor problems, nationalization of assets, or weather conditions. This type of risks can be reduced by assembling a portfolio with significant diversification, so that a single event affects only a limited number of the assets.

Now that we've determined the fundamental types of risk, let's look at more specific types of risk, particularly when we talk about stocks and bonds. 

Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks.

Market Risk - This is the most familiar of all risks. Also referred to as volatility, market risk is the the day-to-day... [continues]

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