15.2.2 Types Of Risks

Types of Risks

Investing in the markets entails the following types of risks, each of which can add to the uncertainty of expected returns for a particular security:

Inflation Rate Risk

Inflation rate risk is the risk that inflation will reduce future purchasing power and the real return on investments.

Business Risk

Business risk is the risk that a company’s earnings will be reduced as a result of factors such as a labor strike, the introduction of a new product into the market, or the outperformance of a competing firm. The uncertainty regarding a company’s future performance is its basic business risk.

Political Risk

Political risk refers to the risk of unfavorable changes in government policies—for instance, the government may increase taxes on foreign direct investment, making it less attractive for foreign investors. This risk also encompasses the instability associated with investing in a particular country, such as a war-torn region.

Liquidity Risk

A liquid asset is one that can be bought or sold at a fair price and converted to cash on short notice. Liquidity risk is the risk that an investor will not be able to buy or sell a security at a fair price quickly enough due to limited buying or selling opportunities.

Systematic and Non-systematic Risk

The risk of a portfolio stems from the combined risks intrinsic to the various securities within it. While certain risks can be mitigated or diversified away, others, known as systematic risks, cannot be eliminated through diversification.

Systematic Risk

Systematic risk, also known as market risk, is associated with factors such as the business cycle, inflation, and high interest rates. When stock market averages fall, most individual stocks in the market also fall. When interest rates rise, nearly every bond and preferred share decrease in value. Systematic risk cannot be diversified away.

    flowchart LR
	    title(Systematic Risk)
	    marketRisk[Systematic Risk: \n - Market Risk, Business Cycle, Inflation, High Interest Rates]
	    stockMarketAverages[Stock Market Averages Fall]
	    individualStocks[Most Individual Stocks Fall]
	    interestRates[Interest Rates Rise]
	    bondsAndShares[Bonds & Preferred Shares Decrease in Value]
	
	    marketRisk --> stockMarketAverages
	    marketRisk --> interestRates
	    stockMarketAverages --> individualStocks
	    interestRates --> bondsAndShares
	    

Explanation of Diagram:

• Market Risk elements: Listed are various aspects contributing to systematic risk, including the business cycle, inflation, and high interest rates.
• Impact paths: Arrows show how market influences lead to specific outcomes in stock and bond prices.
• Individual elements: Each entity is a part of the systematic risk and shows the chain of impact. This flowchart clarifies the propagation of effects under the influence of systematic risk on different financial products.

Did You Know? The more a portfolio gets diversified within a certain asset class, the closer it starts mirroring the market for that asset.

Non-systematic Risk

Non-systematic risk, or specific risk, is the risk that a particular security or a specific group of securities will deviate from market expectations. This type of risk can be mitigated through diversification. For instance, the stock of a bank could increase while the S&P/TSX Composite Index falls, or financial companies could see declines that are more pronounced than those of the index itself.

    flowchart LR
	    nonSystematicRisk[Non-systematic Risk] -->|Specific to Company| bankStockIncrease[Bank Stock Increases]
	    nonSystematicRisk -.->|Can be mitigated by| diversifiable
	    nonSystematicRisk -->|Specific to Sector| financialDecline[Financial Companies Decline]
	    
	    marketIndex[Market Index #40;e.g., S&P/TSX Composite#41;]
	    marketIndex -->|Contrasts with| bankStockIncrease
	    marketIndex -->|Contrasts with| financialDeclare
	
	    diversifiable[Diversifiable Through Diversification]
	
	    classDef boxStyle fill:#bbf,stroke:#333,stroke-width:2px;
	    classDef exampleLine stroke:#333,stroke-width:1px,stroke-dasharray: 5, 5;
	    class nonSystematicRisk,marketIndex boxSyle;
	    class diversifiable exampleLine;

Explanation:

• Non-systematic Risk: This node represents the specific risks associated with individual securities or sectors.
• Bank Stock Increases: Demonstrates an example where a bank’s stock might increase in value even if the overall market is declining.
• Financial Companies Decline: Shows how a specific sector such as financial companies could decline, contrasting with the broader market performance.
• Market Index (e.g., S&P/TSX Composite): Represents the general market performance, used as a baseline to illustrate how non-systematic risk can cause deviations.
• **Diversifiable Through Diversification: **This connection indicates that non-systematic risk can be mitigated through diversification. This flowchart effectively captures the essence of non-systematic risk, highlighting its independence from market movements and showing how diversification can reduce its impacts.