*Disclaimer: Any Information found on website is for education purposes and is not tailored to the investment needs of any specific investor. Investing involves risk, including risk of loss.
Nonsystematic risk is the only type of risk that can be reduced through diversification. They are specific risks that are unique to a specific industry, business enterprise, or investment type. The following are some of the most common nonsystematic risks.
Capital risk is the potential for an investor to lose some or all of their money. This can be unrelated to an issuer’s financial strength.
For instance, if you invest in 100 stocks of ABC Company and it goes bankrupt. You have the potential of losing your total invested principal or lose partial if you sell before price of stock drops to zero.
A business risk is an operating risk, that can be caused by poor management decisions. Best case, earnings are lowered; worst case, the company goes out of business and common stockholders could lose their entire investment.
For instance, if X company introduces a new product that turns out to have a narrow market or underestimates a competitors new product and failing to compete. These are two examples of poor business decisions that impact the price of a company’s stock. A great example occurred in 1962, when chevy released their new car model Nova in spanish speaking countries. They did poorly in these countries due to “Nova” translate to “Don’t go”. Why would you buy a car that doesn’t go? Chevy failed to do sufficient research in the name and this is considered a business risk that can bankrupt most businesses. Keep in mind this example is a myth but it does show the importance of doing research when making management decisions.
Financial Risk (Credit Risk)
A financial risk mainly relates to companies who use debt financing (leverage). If a company is unable to meet the interest and principle payments on those debt obligations could lead to bankruptcy and eventually total loss for the stockholders.
Call risk is the risk that a bond might be called before maturity and an investor will be unable to reinvest the principle at a comparable rate of return. For instance, if interest rates fall, bonds with higher coupon rates are most likely to be called.
Prepayment risk is the risk that a borrower will repay the principle on a loan or debt instrument (bond) before its maturity and lender wouldn’t receive anymore interest payments.
Currency risk is the possibility that an investment in one currency could decline when compared to exchange rate with the U.S. dollar. This is highly important when you invest in foreign securities or any security denominated in a foreign currency. Keep in mind that currency is always quoted in relative terms between two currencies.
Liquidity Risk (marketability risk)
Liquidity risk is the possibility that an investor may not be able to sell an investment quickly at a fair market price. A great example is fixed assets such as real estate, fine art or collectibles are generally not liquid. All this means is that it would be hard to sell or buy the assets quickly.
A regulatory risk is a risk that occurs when a change in the rules has a dramatic effect on the the performance of a business and entire business sectors in that industry. When the rules change a business needs to comply and can effect individual companies and industries almost overnight.
For instance, if the Environmental Protection Agency (EPA) or the Food and Drug Administration (FDA). The new rules that are created can create problems for a companies business model and their ability to be profitable.
Legislative risk is the risk in changes in the law. Keep in mind only a legislative such as congress can pass a law. A great example is a change in the tax code.
Political risk is related to the potential instability of a country. This can occur in emerging economies but can occur in highly developed societies.
- Sovereign Risk:
- is defined as a country defaulting on its commercial debt obligations. When a company is at risk of defaulting on its debt, the impact creates a chain reaction on financial markets.
Overall these are the risk that one can diversity their portfolio to reduce risk.