An investor needs to be aware that there is a risk associated with making any investment and the return they are rewarded with usually reflects the risk involved. This guide explains some of the main types of risk. 1. Stock specific riskThis is the risk that there might be a reduction in the expected return as a result of some event or circumstance specific to a company. For example, the fortunes of Glaxo in the 1980s and 1990s were linked to the success of drugs such as Zantac. 2. Market RiskThe risk that an event might occur that would affect the stock market generally. For example, virtually all shares on the stock market fell in the great bear market of 1973 - 1974, during the 1987 crash, and the credit crunch in 2008 and 2009. 3. Currency RiskWhere investment is overseas, Sterling may appreciate against the investing currency. During 2004 Sterling rose against the US dollar, almost completely eliminating the capital growth from investments in US equities. During the credit crunch, losses for a Sterling investor in Japanese equities would have been almost eliminated by the strengthening Yen. 4. Geographic RiskA major “act of God” can have a disastrous effect on the performance of a country’s businesses or industries. Economist losses from natural disasters were greater in the 1990s than in the previous four decades combined. In 1998 along with storms, floods, droughts and fires caused almost $100 billion in economic losses, equivalent to the entire GDP of New Zealand! 5. Political RiskA change to government with different fiscal or monetary objectives. This could be as a result of an election or perhaps coup or revolution. The political risk of investing in somewhere like China is much greater than in the UK or the USA as the government is more likely to intervene in the economy.
Interest rate risk: Rate rises lead to falls in fixed interest securities. Rate falls reduce returns from cash. Re-investment risk: When income received during the life of the investment cannot be re-invested at the predicted rate. Business risk: The management of a company makes poor business decisions a whole industry may go into a decline. Default risk: When the issuer of a bond fails to pay the interest or repay the capital. Also applies on structured products if the counterparty fails. Inflation risk: The real value of the investment and the income from it falls because of inflation. Liquidity risk: The investment may be difficult to sell or encash. Risk of catestrophic loss: The risk of total failure of an investment. Often hidden in an apparantly low volatilty, but high return investment which in reality is “too good to be true”.
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