What is Risk?

 

General Definition of Risk

 

When some people think about risk, they think “Will I lose my money?”  That is not what professional investors think of when they think of risk.  They think of the up and down price change of a stock or a bond – the more the price moves up or down, the riskier the investment.  To a large extent, the acceptance of some risk is what distinguishes an "investment" from "savings."  Controlling risk is a reasonable goal, but a cardinal rule of investing is that the potential for greater investment returns is always accompanied by greater risk.  Remember, risk is the up and down price changes an investment goes through.

 

Specific Risk – Risk that is unique to a particular company.  Experienced investors minimize this risk by investing in many different companies – spreading your money over the stock of many different companies is one aspect of “diversification.”  This risk management tool is based on the idea “Don’t put all of your eggs in one basket.” 

 

Market Risk – This is the risk of investing in the stock market in general.  The value of the stocks of individual companies tends to change, to a significant degree, in tandem with the stocks of other companies.  This up and down price volatility is the risk of the stock market in general – Market Risk.  All stock investments are affected by market risk. 

 

Interest Rate Risk – The value of fixed income investments, especially government or corporate bonds, are affected by the current interest rate.  In general, when interest rates rise, the value of bonds drop.  Interest rate risk is the risk that the value of a bond will drop because of an increase in the interest rate.

 

Managing Risk

 

Diversification is the most important tool for reducing risk. Owning other companies helps to reduce business risk. Owning other types of investments, such as investing in bonds and real estate, reduces the market risk of investing solely in stocks.

 

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External Links

 

Investopedia – Risk

Market Risk

Specific Risk

Diversification

Interest Rate Risk