Understanding different types of risk

In investing, risk takes many forms. Here's your guide to understanding some of the most important ones.

Adam Zoll 7 July, 2014 | 6:00PM
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Question: From time to time I hear terms such as "credit risk, "currency risk" and "tail risk" mentioned with regard to investing. Can you explain what these and other types of investment-related risk are?

Answer: The risk/reward principle is among the most central tenets of investing. Simply put, the greater the risk one is willing to take, the higher one's potential gain. But risk can take many forms. So many, in fact, that the term can be applied to almost any source of uncertainty. As you read this, you might be exposing yourself to career risk if you're at work and the boss thinks you're wasting time, or eye-strain risk if you forget to blink enough.

Investors tend to home in on a specific set of risks--particularly those with the potential to directly or indirectly reduce investment performance. Some risks, such as economic risk, are rather broad, affecting multiple asset types, while others are more focused.

To help readers understand some key types of risk and how they relate to investing and personal finance, we offer the following set of definitions. It is by no means comprehensive. In fact, after reading it you may be inclined to identify other forms of risk present in your own daily life--marriage risk if you forget yet again to stop at the grocery store on the way home, health risk if you say yes to that second piece of cake, and so on. Those risks, at least, are within your control (more or less). As investors, it's managing the risks we can't control--including the following--that's the real challenge.

Credit risk: The likelihood that a bond issuer will be able to repay its debts. Bond issuers with poor credit ratings--meaning those considered at higher risk of defaulting and thus being unable to meet their obligations--typically must pay higher yields to attract investors. Investors must weigh the credit risk associated with a bond against its potential payout over time.
Of particular concern to: High-yield bond investors

Currency risk: Chances that an investment will gain or lose value based on changes in currency exchange rates as opposed to other factors, such as company fundamentals. The intrinsic value of a stock or bond may theoretically rise, but if the currency in which it is denominated falls far enough relative to the Canadian dollar, the price of the asset could actually decrease, and vice versa.
Of particular concern to: International-stock and international-bond investors

Economic risk: Impact that a negative change in the economy could have on an investment. This is one of the broadest of all investment risk factors.
Of particular concern to: Investors owning more speculative fare, such as cyclical stocks

Geopolitical risk: The chance that events on the world stage will affect a security's performance. For example, turmoil in the Middle East may cause oil prices to rise, causing a drag on economic growth and on the profits of some companies. Or an election in another country may bring to power new leadership that adds to or subtracts from regulation of a given industry.
Of particular concern to: International-stock and international-bond investors, or those owning the stocks of North-American companies with significant revenues overseas

Inflation risk: The effect that broadly rising prices have on the value of an asset. Some bonds, in particular, may be subject to inflation risk because they pay a fixed rate of interest, and if prices rise, it erodes the purchasing power of that fixed rate and thus the value of the bond itself. Some bond types, including real return bonds, are designed to keep pace with inflation, thus hedging out this risk.
Of particular concern to: Bond investors

Interest-rate risk: Impacts resulting from a rise in prevailing interest rates. This has a very strong effect on the value of bonds because as rates rise, the value of existing bonds falls. A bond fund's sensitivity to interest-rate movements is expressed using a metric called duration. For example, a bond fund with an average effective duration of 5 years might be expected to lose 5% of its value for every percentage point that rates rise (with the fund's yield offsetting some of this loss). Inflation-protected bonds may still lose value if interest rates rise. Rising rates also could hurt stocks as investors look for higher returns to justify the risk they are taking relative to so-called safer investments, though the fact that rising rates often occur during times of economic expansion helps offset some of this pain for many securities. Dividend-paying stocks, which tend to be less economically sensitive, may be more negatively affected as cash flow growth can be modest even in a robust economy.
Of particular concern to: Investors who own bonds and dividend-oriented stocks

Longevity risk: In personal-finance parlance, the chance of outliving one's money. Calculating how much an individual needs to save for retirement requires weighing factors such as savings rate, income needs in retirement and life expectancy. The chances of living beyond an age when one has the financial resources to support one's self is considered a form of longevity risk.
Of particular concern to: Anyone planning for retirement

Market risk: The chance that an investment may lose value because broad issues affecting similar securities as opposed to causes specific to the investment. For example, the shares of a company that is doing well may still lose value during a severe market downturn or pullback within the company's stock sector.
Of particular concern to: All investors

Tail risk: The possibility that a highly improbable event will occur. The term refers to a bell curve distribution pattern of potential outcomes, with the least likely of these outcomes represented on the left edge of the curve by what looks like a thin tail. In investing parlance, it's short-hand for a remote but very real possibility. Examples might include another global financial crisis, a natural disaster, or an unexpectedly severe weather season.
Of particular concern to: All investors

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Adam Zoll

Adam Zoll  Adam Zoll is an assistant site editor with Morningstar.com

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