4.4:
Types of Risk: Systematic Risk
Systematic risk is fundamental to the market, reflecting the impact of economic, financial, and geopolitical factors. This risk affects the entire market, not just a particular stock or industry.
Here are the main types.
Market Risk refers to the risk when the entire stock market declines. Peter, invested in the stock market, saw a decline in his portfolio during the year twenty-twenty as global markets fell because of the pandemic.
Interest Rate Risk refers to changes in interest rates affecting investment values. Peter, holding long-term bonds, found their value decreased when interest rates increased.
Inflation Risk is the loss of purchasing power due to rising prices. Peter's deposits lost some value due to the time value of money during periods of high inflation.
Currency Risk occurs with fluctuations in foreign exchange rates. Peter, who invested in European stocks, faced losses when the Euro weakened against the Dollar.
Socio-political risk, part of geopolitical risk includes changes due to political instability or policies. For example, an increase in tax rates could negatively impact the stock market.
Understanding these systematic risks is essential for investors to prepare and protect their investments against broad market changes.
4.4 Types of Risk: Systematic Risk
Systematic risk is inherent to the market and reflects the impact of economic, financial, and geopolitical factors. It affects the entire market rather than specific stocks or industries. This type of risk is unavoidable and cannot be mitigated through diversification.
Market risk refers to the possibility that the overall stock market will decline, impacting the value of all investments. This risk is often driven by macroeconomic factors such as economic recessions, financial crises, or global events that negatively affect market sentiment and performance.
Interest rate risk occurs when changes in interest rates impact the value of investments. For example, an increase in interest rates typically causes the value of long-term bonds to decrease as the present value of their future cash flows diminishes. This type of risk is particularly relevant for fixed-income securities, where the value is inversely related to interest rate movements.
Inflation risk involves the potential loss of purchasing power due to rising prices. When inflation is high, the real value of investments that yield fixed returns diminishes, as the returns may not keep pace with the increasing cost of goods and services. This risk affects any investment with nominal returns and does not adjust for inflation.
Currency risk, also known as exchange rate risk, arises from fluctuations in foreign exchange rates. Investors with holdings in foreign currencies or foreign-denominated assets are exposed to this risk. Changes in exchange rates can affect the value of these investments, either positively or negatively, depending on the direction of the currency movement.
Socio-political risk includes the effects of political instability, government policy changes, and other socio-political events on investments. This can encompass changes in tax policies, regulatory environments, and political unrest. Such events can have significant and often unpredictable impacts on market performance and investor confidence.
While these risks cannot be entirely avoided, measures such as strategic asset allocation, hedging, and staying informed about global economic and political developments can help investors better manage the impact of broad market changes on their portfolios.