Diversification is one of those things all investors ought to know about. We all know it means to lower the risk of your portfolio, but where exactly does this risk come from?
For example, is the risk from a specific company or asset we hold? Or is there some macroeconomic factor leaving us exposed to risk? These are the types of questions we must ask.
On that note, here are ten different types of risk your investment portfolio could be exposed to right now:
Interest Rate Risk – When you hold bonds or other assets that pay a fixed rate (i.e., preferred stocks), you are exposed to interest rate risk. Namely, if interest rates increase, the value of your asset will decline.
Business Risk – Business risk comes from owning a specific security or stock. It represents the risk of that company going bankrupt or becoming unable to service its debt. You can minimize this type of risk by spreading your capital across many companies and industries. Mutual funds and exchange traded funds can make this easier for you.
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Credit Risk – This type of risk typically deals with bonds. Specifically, credit risk refers to the bond issuer’s ability to meet interest payments as they come due. And eventually, the principal amount too. However, higher interest rates often accompany higher credit risk assets.
Call Risk – Again, this type of risk deals mainly with bonds. Call risk stems from the chance that the bond issuer may call the bond before it reaches maturity. Typically, this is seen when interest rates are falling. Companies sometimes want to retire their current debt and replace it with new debt at a lower interest rate.
5. Inflation Risk – Every investment is exposed to inflation risk since it deals with the purchasing power of an asset. The higher inflation rates go, the lower the real return on your investments. Meaning they will have less purchasing power as inflation goes up.
6. Liquidity Risk – Liquidity risk deals with how quickly and easily you are able to exit your investment. With most publicly traded stocks this is not an issue since there is often high demand. However, when it comes to private holdings or other assets like real estate, you may not be able to liquidate your position as quickly and cash out.
7. Market Risk – Market risk affects all securities in the same way. Unlike business risk, you cannot remove market risk from your portfolio through diversification. In order to reduce your exposure to market risk, it will require advanced tactics like hedging with options, for example.
8. Reinvestment Risk – Reinvestment risk primarily stems from owning bonds. It becomes an issue when interest rates are declining and your bond is reaching maturity (or gets called early). When this happens, returns are lower across many debt instruments.
9. Social and Political Risk – This type of risk deals with any negative effects caused from political or social sources. Whether it’s a new government regulation or a social movement targeting a particular company or industry, these can harm the value of an asset.
10. Exchange Rate Risk - Exchange rate risk arises when your investment involves the conversion of currencies. For example, assume you have a foreign asset that you convert to US dollars. If the US dollar is strong, your returns are lower (and vice versa).
Conclusion
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