Types of Portfolio Risks
Investors face several forms of risk to their investment portfolios. These risks are the uncertainty that a portfolio can earn its expected rate of return. Risk can and will affect all asset classes within a portfolio (i.e. stocks, bonds, real estate, commodities). The causes of risk are varied.
First is market risk. Market risk is the possibility that a portfolio will be affected by the overall activity of the market as a whole. For example, the financial crisis of 2008-2009 resulted in the market values (stock prices) of even profitable businesses decreasing significantly.
Business risk is another threat to an investor's holdings. Business risk is when a particular business' management may be incompetent or product and/or service becomes obsolete. As a result, they go out of business.
Next is sovereign risk. Sovereign risk is associated with changes in the environment that businesses operate in. These can be changes in regulations, or laws or in extreme example a complete change (many times violent) in the government. Any of the above can have an impact on business and by extension those that invest in those businesses. In extreme situations such as when a government nationalizes a particular industry (i.e. oil), investors' investments can be made worthless.
Liquidity risk is the ability of an investor to convert their investment(s) into cash when necessary. In short, it is the risk that when an investor is ready to sell there is no one willing to buy.
Interest rate risk is the result of central banks such as the US Federal Reserve attempting to manage their country's economy. Through various mechanisms central banks can provide or reduce the amount of money in an economy. These efforts generally cause interest rates to move up and down. Changes in interest rates affect the value of income generating assets such as bonds, CDs, real estate and the stock market.
Next, as most of investors have a long-term time horizon, there is inflation risk. Inflation risk is when the purchasing power of an investment can be significantly reduced. Fixed income assets such as bonds are more susceptible to inflation risk than stocks are.
The last form of risk I wish to address is duration (time until maturity) risk. Duration risk is associated with fixed income producing investments, such as bonds. Because bonds prices have an inverse relationship with their yield, meaning as the price of a bond goes up its yield goes down. The longer the duration of a bond the greater its yield and a result these longer duration bonds have a greater sensitivity to price movements.
I'll address ways to mitigate these risks in my next guide.
The content contained herein represents the author's opinion and should not be regarded as investment advice, which is provided only to Agnew Capital Management LLC clients upon completion of a written plan.