Most investors know that they should evaluate their risk tolerance when considering an investment. Oftentimes, investors think of risk only in terms of possibly losing money. However, in the investment world, risk is broadly defined as the probability that the actual return from an investment will be different from its expected return. Actual returns (making or losing money) can be affected by a number of factors, and total risk is a measure of variation in return due to all sources.
General risk refers to factors that lie outside individual companies, but that affect an entire class of investments, or the market as a whole (although individual companies may be affected to varying degrees). One type of general risk, known as market risk, may be a function of political, economic, and sociological events, or changes in investor preferences. For example, market risk occurs when the overall business climate changes, bringing expectations of lower corporate profits in general, and causing the larger body of common stock prices to fall.
A second general factor that may broadly affect all companies is interest rate risk—the fluctuations in the general level of interest rates. The bond market is particularly sensitive to interest rate risk in that bond prices tend to move in the opposite direction of interest rates. Although fixed-income securities (such as bonds) are generally the securities most affected by interest rate risk, other investment vehicles may be affected as well. Companies that borrow heavily for plants and equipment (e.g., utilities) may see their common stock prices affected by changes in the cost of borrowing.
A third general risk factor is purchasing power risk—the impact of inflation (a general rise in prices) or deflation (a general fall in price levels) on an investment. Purchasing power risk is a reflection of the uncertainty of price levels during the time an investment is held, particularly the inability of a particular investment to keep pace with inflation. For example, if an investment returns 3% annually, but inflation averages 4% annually during the holding period, the investor will be losing purchasing power by holding the investment. Purchasing power risk is generally highest in investments paying relatively low fixed-interest rates, such as savings accounts.
In contrast to general risk, specific risk is that portion of total risk that is unique to a firm, industry, or property (in the case of a real estate investment). Specific risk is typically subdivided into business risk and financial risk.
Business risk is the risk associated with the nature of the enterprise itself (or the industry in which the enterprise resides) and measures the company’s ability to meet its obligations, remain a profitable entity, and provide acceptable returns to investors. It is generally believed that like kinds of firms or properties have similar business risk. However, among similar businesses, differences in management, operating costs, and market opportunities can create different levels of business risk.
Financial risk measures a company’s mix of debt and equity used to finance its operations. Debt creates legal obligations (i.e., principal and interest payments) that must be met before earnings are distributed to owners (e.g., dividends to stockholders). The larger the proportion of debt, the greater the financial risk.
Risk can be affected by political, social, and economic influences. Consequently, fitting individual risk tolerance to specific investments is an ongoing process that examines the interplay between the individual investor’s objectives and the constantly changing sources of risk that can impact investment returns.