Finance Business risk A measure of the risk associated with a particular company in which you invest (or the issuer from whom you buy bonds). In practical terms, it’s the chance that the company may decline or go bankrupt due to some company-specific problem (bad management decisions, business obsolescence, toomuch debt, etc.) and, therefore, you’ll lose some or all of your money. While even the largest, most well-established companies face some business risk, it’s a particularly important consideration with small-cap, startup companies that are still building their businesses. Market risk This is the opposite of business risk, describing the possibility of an entire market (or segment of the market) suffering a decline in value due to large-scale economic conditions or events. It’s important to remember that even the best-managed, most prosperous companies can suffer from market risk; witness what happened in the aftermath of the financial meltdown of 2007-2008. Political risk This is the chance of an unfavourable government action – changes in tax rates, regulations, foreign ownership rules, etc. – affecting the business prospects of a particular company in which you’ve invested. Such issues are of particular concern when investing overseas, where the rule of law isn’t as strong as it is in North America. It can also be important for companies operating in highly regulated sectors of the economy (mining and energy, for example). Currency risk A particular concern for snowbirds. This is the chance that the fluctuations in the relative values of international currencies could affect the value of your portfolio and, by extension, impact your ability to meet your day-to-day expenses or pay for larger lifestyle goals in foreign currency. Currency risk can be notoriously difficult to predict and manage, even for active traders and professional managers. Liquidity Risk The possibility that an investor may not be able to sell (or buy) an investment because there simply aren’t enough buyers (or sellers). Liquidity depends largely on the asset in question: it can take several weeks or even months to sell a privately held business, for example, or a rental property. On the other hand, liquidity risk is rarely an issue with large, blue-chip stocks, government bonds or mutual funds/ETFs. Credit risk The possibility that a bond issuer will not be able to pay interest or repay principal. Credit risk is usually a measure of the financial health of the underlying issuer and, therefore, typically more of an issue with corporate bonds than with government bonds. But this is only a general rule: most investors would consider bonds from, say, the government of Mexico to be a much higher credit risk than the bonds of Apple Inc. Inflation risk Describes the possibility that the value of a given asset could be eroded as the cost of goods and services slowly increases over time. In the current low-interest-rate environment, a portfolio with an oversized allocation to bonds and interest-bearing investments (GICs, Treasury Bills, etc.) faces greater inflation risk than a portfolio that includes a reasonable allocation to equities, which tend to offer returns above the rate of inflation. Interest-rate risk The chance that rising interest rates cause the value of your bonds or other fixed-income investments to decline. Over the past several years, it’s been easy to ignore interest-rate risk – most central banks around the world have kept interest rates low as a way of stimulating the economy. However, recent moves from the U.S. Federal Reserve suggest that this time may be ending, and we may be entering a period of rising interest rates. Different kinds of risk First things first: to truly understand risk, we need to get beyond the bare-bones definition that most people give – something along the lines of “the chance of losing money.” Sure, that’s what risk always comes down to in the end. But the definition doesn’t offer much insight, or lead us to any possible solutions as to how we might be able to prevent risk from derailing our financial goals. Instead, what we need to do is learn about the different types of risk which we face when we invest. These include: 28 | www.snowbirds.org
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