Investment decisions are influenced by various types of risk. Market risk, also known as systematic risk, is the inherent volatility of financial markets, influencing the value of investments. In essence, this type of risk is, in almost all cases, not possible to avoid. By acknowledging and comprehending market risk’s influence, you can employ strategies to hedge against its impacts and optimise your portfolios. For example, diversification across various asset classes and geographic regions can partially mitigate this risk, aiding in stabilising portfolio performance in times of market volatility.
On the other hand, there is also unsystematic (or ‘specific’) risk. This pertains to risks inherent to a particular asset or sector and thus is easier to avoid. For instance, company-specific risks might include management changes, product recalls, or takeovers. Sector-specific risks could stem from regulatory changes or shifts in consumer preferences affecting specific industries. Whilst diversification can help mitigate unsystematic risk to an extent, it cannot entirely eliminate it. Strategies such as asset allocation and thorough due diligence are vital in mitigating this risk.
Inflation risk arises from the erosion of purchasing power due to a rise in the general price level of goods and services. Investments failing to outpace inflation may result in diminished real returns. Strategies to mitigate inflation risk involve investing in assets with returns exceeding inflation rates, such as equities, real estate, or Treasury Inflation-Protected Securities (TIPS).
Political risk stems from changes in government policies, geopolitical tensions, or legislative decisions impacting investments. Diversification across regions and sectors, investing in stable economies, or utilising hedging instruments like options or futures can help mitigate political risk.
Concentration risk emerges from an overexposure to a particular asset class, sector, or individual investment. This commonly arises from an Employer’s reward scheme whereby an Employee is given shares as a bonus and thus over time the Employee builds up a large concentration of their assets in one Company’s shares. Diversification across various asset classes and industries can mitigate this risk. Additionally, implementing risk management techniques like setting investment limits or employing stop-loss orders can help control exposure to concentration risk.
Indeed, there are many other types of risk, click here to see our previous article explaining many of the most common types of risk you may encounter.