The stock market is at once both the biggest creator of wealth in modern times and a risky activity, and this is no coincidence. When economists analyze risk, defined in one sense as exposure to a chance or loss or damage, they tend to find that risk and potential reward are positively correlated. The stock market, one of the most profitable investment vehicles of our time, has a variety of risks, which new investors should recognize and understand.
Basic Categories of Risk: Systematic Risk
There are two types of risk that will always be present in most investments: systematic risk and unsystematic risk. Systematic risk can be thought of as macrorisk, or a game changing risk. For example, political events, natural disasters, nuclear attacks and other fairly unpredictable events could at any time affect the stock price of many stock market assets, and therefore your assets as well. It is very difficult to avoid systematic risk, although professionals try to anticipate these events because predicting them can be very profitable.
Basic Categories of Risk: Unsystematic Risk
Unsystematic risk is not as unavoidable as systematic risk, and stems from specific events that would not affect the stock market generally, but would affect individual stocks. This includes fraud or allegations of fraud, a worker strike, recalls, mergers and other events. These risks are specific to either industries or even specific firms, and therefore, this risk is not impossible to avoid. Diversification, the strategy of investing in many different types of assets, reduces unsystematic risk.
Credit Risk and Country Risk
Credit risk is the risk that a firm will be unable to deal with its obligations, and therefore the asset will become unprofitable. So long as the firm has adequate cash flows (visible by using the statement of cash flows, a required SEC filing for American firms), credit risk is not a major asset concern. Country risk refers to the risk that a country will change the rules under which its financial system operates in some way that affects that country's native financial instruments and assets; country risk is also known as political risk. This type of risk is more common in stock exchanges in the developing world, rather than in Western societies.
Market risk is risk associated with daily fluctuations in stock price. Market risk is also referred to as volatility; assets with high volatility (market risk) are likely to fluctuate greatly in stock price, whereas assets with low volatility are more immune to fast, large price changes. Volatility is important in the stock world for a variety of reasons. The more volatile a stock, the more potential for profit there may exist (which is why some investors focus on identifying growth stocks, which have the capability for explosive growth), but at the same time, there is also the possibility of dramatic loss. The less volatile the investment, the less on average the return will be to that investment. Stocks are the most volatile of financial assets.
The final type of risk associated with stock market transactions is liquidity risk. Liquidity risk refers to risk that the stock will not be able to be traded fast enough to avoid or loss or capitalize on a potential profit. Liquidity risk can be avoided by making sure the daily volume of share trading is above a certain level, so that the investor can be more assured that the desired trades will go through in a timely manner.
- Microeconomics, 7th Ed.; Pyndick and Rubinfeld; Prentice Hall, 2008
- Financial Accounting, 2nd Ed.; Dyckman and Pfeiffer; 2009
- Photo Credit Photo by Cohdra. Courtesy of Morguefile.com, http://mrg.bz/sn4S0E
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