Types of Risk

There are two basic types of risk:
Systematic Risk - A risk that influences a large number of assets. An example is political events. It is virtually impossible to protect yourself against this type of risk.

Unsystematic Risk - Sometimes referred to as "specific risk". It's risk that affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect yourself from unsystematic risk. (We will discuss diversification later in this tutorial).

Now that we've determined the fundamental types of risk lets look at more specific types of risk, particularly when we talk about stocks and bonds:

Credit or Default Risk - This is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bond's within their portfolio. Government bonds, especially those issued by the Federal government, have the least amount of default risk and least amount of returns while corporate bonds tend to have the highest amount of default risk but also the higher interest rates. Bonds with lower chances of default are considered to be Investment grade,?and bonds with higher chances are considered to be junk bonds. Bond rating services, such as Moody's, allows investors to determine which bonds are investment-grade, and which bonds are Dunk?

Country Risk ?This refers to the risk that a country won't be able to honor its financial commitments. When a country defaults it can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit.

Foreign Exchange Risk ?When investing in foreign countries you must consider the fact that currency exchange rates can change the price of the asset as well. Foreign exchange risk applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you are a resident of America and invest in some Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the American dollar.

Interest Rate Risk - A rise in interest rates during the term of your debt securities hurts the performance of stocks and bonds.

Political Risk - This represents the financial risk that a country's government will suddenly change its policies. This is a major reason that second and third world countries lack foreign investment.

Market Risk - This is the most familiar of all risks. It's the day to day fluctuations in a stocks price. Also referred to as volatility. Market risk applies mainly to stocks and options. As a whole, stocks tend to perform well during a bull market and poorly during a bear market olatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behavior, or emperament,?of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money from stocks, volatility is essential for returns, and the more unstable the investment the more chance it can go dramatically either way.

Inflation Risk - Because the cost of living increases each year (call inflation), some years a little, some years a lot, you need to get some return on your investments equal to or above the inflation rate, or your savings and investments will lose ground. For example, if you keep your money in a savings account or a certificate of deposit that is earning 6% and the inflation rate is 4%, your real return is only 2%. If it is earning less than the inflation rate, you are really losing money. You may have reasons to do this in the short run, but in the long run, it is not a good idea.
As you can see, there are several types of risk that a smart investor should consider and pay careful attention to. Deciding your potential return while respecting risk is the age old decision that investors must make.

How Much Risk Are You Willing To Take?
Besides a broad understanding of risk, ask yourself what your risk tolerance is. To be a good investor, not only must you know where you stand financially, it's also crucial to understand your own investment psychology.

To find out your risk tolerance level, think of your past experiences, especially those related to your work and finances. (Some people drive very fast but can't make financial decisions.) If you had changed your job without thinking whether the return prospect would be worthwhile, your risk tolerance should be quite high. But if you're the type who checks the price of item in at least 3 or 4 shops before buying one, you're quite careful with your money.

Knowing your risk tolerance is critical for choosing suitable investment options and making investment decisions. If you're inclined toward a high- risk-high- reward stake, keep reminding yourself and draw a clear loss-limit. This doesn't imply giving up your appetite for risk since risk takers may have different views from others.

If you're a conservative investor and take quite a long time to make a decision, the plus side of this is that you won't invest rashly. On the other hand, your may miss out on a good investment proposition. Your risk tolerance is a thing that you must find out for yourself. And perhaps you may allow yourself to be a little more adventurous. But set a limit to it. (It usually happens that neither the risk taker nor the risk averse has set his loss limit, hence he has problems in trying to control his investment decisions and investment options.)

Whatever your attitude to risk, the decision and consequence is yours and yours only. And the proof of it will be your return and time targets. There are many good things in life. Don't let investment anxiety cause you ulcers or sleeplessness!

Source from: http://www.moneysitter.com/Investing/investing3b.htm