To start with, let's go over the basics and see what the different types of risks are. Then we'll talk a little bit about the risk-reward trade-off, and summarize with the one investing rule that will never fail to help you make money and achieve your goals. Systematic risk is risk within the entire system. This is the kind of risk that applies to an entire market, or market segment. All investments are affected by this risk, for example risk of a government collapse, risk of war or inflation, or risk such as that of the credit crisis.
It is virtually impossible to protect your portfolio against this risk. It cannot be completely diversified away. It is also known as un-diversifiable risk or market risk. Unsystematic risk is also known as residual risk, specific risk or diversifiable risk. It is unique to a company or a particular industry. For example strikes, lawsuits and such events that are specific to a company, and can to an extent be diversified away by other investments in your portfolio are unsystematic risk.
Within these two types, there are certain specific types of risk, which every investor must know. Credit risk is just the risk that the person you have given credit to, i. Management can also cut unnecessary expenses and develop a stricter budget with low overhead to ensure operations can continue even in challenging economic landscapes. Compliance Risk Regardless of the industry, businesses must follow laws and regulations that restrict various processes.
On the other hand, the Environmental Protection Agency EPA holds organizations to a standard to decrease negative effects on the environment. While regulations may restrict companies, those that are non-compliant could receive penalties, fines, or could even be shut down.
Organizations should routinely review their risk compliance and new regulations to ensure that operations are running appropriately. Online employee scheduling software that makes shift planning effortless. Try it free for 14 days. Security and Fraud Risk As technology evolves and more customers are using online stores to shop and share personal information, the risk of hacking increases. Customers can have their credit card information and identity stolen while businesses can experience data breaches.
These security issues damage consumer trust and the company's reputation. However, with effective risk assessment, businesses can build security solutions to detect threats, alert users of unusual activity, and stop attempted breaches. Management can also hold training sessions to teach employees how to identify and respond to potential risks. Financial Risk Financial risk refers to internal and external events that directly affect a company and its profits.
For example, businesses can extend customers' credit lines or accrue debt from suppliers. To counteract financial risk, organizations can adjust their existing business plans to maintain consistent cash flow and minimize the probability of debt. In general, inflation risk is more of a concern for investors who have debt investments like bonds or other cash-heavy investments.
Although inflation risk may not be the primary concern for investors, it definitely is and should be on their minds when dealing with cash flows over a long period of time in investment vehicles or when calculating expected returns. The longer cash flows are exposed, the more time inflation has to impact the actual returns of an investment and eat away at profits - specifically if inflation is at an accelerated rate. Market risk is a broad term that encompasses the risk that investments or equities will decline in value due to larger economic or market changes or events.
Under the umbrella of "market risk" are several kinds of more specific market risks, including equity risk, interest rate risk and currency risk. Equity risk is experienced in every investment situation in that it is the risk an equity's share price will drop, causing a loss. In a similar vein, interest rate risk is the risk that the interest rate of bonds will increase, lowering the value of the bond itself.
And currency risk sometimes called exchange-rate risk applies to foreign investments and the risk incurred with exchange rates for currencies - or, if the value of a certain currency like the pound goes up or down in comparison to the U. Liquidity risk is involved when assets or securities cannot be liquidated that is, turned into cash fast enough to ride out an especially volatile market.
This kind of risk affects businesses, corporations or individuals in their ability to pay off debts without suffering losses. As a general rule, small companies or issuers tend to have a higher liquidity risk due to the fact that they may not be able to quickly cover debt obligations.
Essentially, if an individual or company is unable to pay off their short-term debts, they are at liquidity risk. Risk management is the process and strategy that investors and companies alike employ to minimize risks in a variety of contexts. Risk management can range from investing in low-risk securities to portfolio diversification to credit score approval for loans and much more.
For investors, risk management can be comprised of balancing or diversifying portfolios with a range of high- and low-risk investments, including equities and bonds.
The general rule seems to go that the wider range of investments that are deemed more or less risky based on how volatile the security is or how drastic its price swings are , the more risk-managed the portfolio and less risky the investment.
There are various strategies companies and individuals alike employ to avoid incurring too much risk. Avoidance of risk is a commonly used strategy by businesses to, well, avoid risk. While the strategy is rather vague, avoidance of risk includes things like opting not to purchase a new factory if the risks to the business outweigh the benefits which, presumably, the company has determined through cost benefit analysis.
Additionally, strategies like risk mitigation seek to minimize the effects of risk instead of avoiding them entirely. For example, a beverage company like Coca Cola KO - Get Coca-Cola Company Report could avoid having to recall a product for health reasons by conducting an inspection of their product before it goes into the retail space and into consumers' hands. Transfer of risk is also a strategy employed to minimize risk by transferring it to another party - a common example of which is insurance.
Although day-to-day operations are often tried and tested to minimise dangers, incidents or unexpected circumstances could still take place, as the last several months have made blatantly clear. Operational risk refers to the risk of loss resulting from failed internal processes, people or systems or external events.
Examples include global crises, IT systems failure, data breaches, fraud, loss of people and litigation, among others. Organisations, therefore, must know the daily functions, processes and systems that are critical to their business operating normally and have plans and procedures in place to manage those risks and ensure 'business as usual'. Software like RiskWare can be incredibly helpful in identifying these critical functions and improving your risk management plans.
While the day-to-day operations of your organisation are important, managing your organisation's strategic goals is just as fundamental to future success.
Strategic risks refers to external causes or circumstances that, if they were to occur, would be serious enough to alter the strategic direction of your business, impacting its future success or failure. All organisations are open in varying degrees to strategic opportunities and threats. Exploring how such changes might affect your organisation will help mitigate the issues that might be created.
Government bodies have in place an array of industry laws, regulations, policies and best practices in place to ensure ethical business practices.
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