How Do Different Types Of Risk Influence A Portfolio?

Essentially, in investment types of risk can be described as the uncertainty of future returns. Since share and stock prices move up and down, potentially changing all day every day, this uncertainty can be very real. The movement of prices, known as volatility, is caused by one or both of two factors. These are:

Market risk and Investment specific risk

Market risk cannot be avoided and has an effect on an entire investment market. It is also known as Systematic Risk. In recent years, this type of risk seems to hit most if not all major stock exchange indices at the same time. In this connected world, very little appears to be safe.

Some things are likely to cause this market risk. For example, there may be significant changes in a national economy. This may and often does take the form of changes to interest rates, inflation or unemployment predictions, GDP growth and so on. Other factors might include changes to taxation rules made by a government.

Obviously, the private investor can only avoid such perils by remaining out of each and every market! In the modern world, with pension funds and mortgage repayment vehicles it is virtually impossible to avoid all stock market risk (information here).

It could be said that broadly, all companies have a similar exposure to systematic risk. However, there are obvious exceptions. For example, the very largest companies in a market - the biggest 15 or so in the FTSE 100, for example - will move on political, economic, environmental and general news issues. In contrast, a company that is the 400th largest on the FTSE is going to move on such news very rarely.

Thus, it could be argued that the very largest firms also have some form of country risk associated with them. This is probably not a bad thing though in many market conditions. After all, when there is non-specific good news, their share price may well benefit!

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Systemic risk is something that was largely theoretical in markets until the banking collapse of 2008 (information here). It has been widely ackowledged that the world's financial system is now more interconnected than ever before and that a failure in one place can have dramatic impacts on other unexpected locations. The banking system is the prime example.

This academic paper discusses it's role in financial markets. This type of risk and it's unexpected consequences has prompted the European Union to form the European Systemic Risk Board to investigate and suggest measures to limit the potential impact and problems that it can cause.

Investment specific risk relates to a company or industry. It is also known as Unsystematic Risk. The factors which cause this are generally not connected to political or national economic factors. Examples of factors which might include Investment specific risk are:

- New competitors entering a market,

- Technological improvements which render existing products or business processes obsolete, or

- Changes to the credit rating (and therefore borrowing costs) of a company

These are types of risk that can be reduced or limited by holding a diversified portfolio. This is possible because different companies will be impacted by the same changes in different ways.

An investor may hold positions in companies that will deliberately move in opposing directions at news of the same events to lower the risk and price volatility in a portfolio. However, should all assets move in broadly the same direction at the same time, this offsetting would not work.

The classic example used to explain this would be to hold shares in an ice-cream company and an umbrella company. If it rains, umbrellas are in demand. If it sunny, ice-cream sells. Clearly this is a very simplistic approach, but it does offer a glimpse into the thinking.

Simply relative

It is worth pointing out that this is ultimately all relative to you and I - the individual owner of the assets. Our individual investment risk tolerance will have a large impact on how we manage a portfolio. For example, some people are frightened of inflation risk and seeing their capital devalued while others are happy to take a chance and accept capital risk.

These can be tricky concepts to understand and get right, but they are worth the effort. Asset allocation (information here) can be a very useful tool in reducing portfolio risk and sometimes boosting annual returns. It is worth pointing out that there is nothing inherently wrong in shunning funds in search of alpha (information here) and focusing on strategies to simply bring in the market beta return (information here).