Many investors associate risk with a loss of principal and indeed that is one definition of risk. However, there are many others, some of which we shall outline below that may be helpful in how you allocate your capital. Some risks are specific to investments in equities, some to fixed income (bond) while other risks are assumed by both equity and bond investors.
If one were to broaden out the definition of risk slightly, included would be systematic risk or the risk associated with an entire asset class such as stocks, bonds, cash, real estate or commodities. This type of risk is undiversifiable as it is associated with every investment within that asset class.
Another form of undiversifiable risk is investment risk or the risk that actual returns are less than expected returns as well as historical returns. For example, if over the past fifty years, including dividends the stock market averaged 9.00 percent per year and that was your expected return, any potential shortfall would be defined as investment risk.
Hypothetically, consider an investment of all of your money intended for equities into one stock – Philip Morris, a global manufacturer and seller of cigarettes as well as other tobacco products. In addition to the two detailed above, what risks would you assume? First and foremost, you would assume company specific risk or the risk that the share price of Philip Morris does not perform at or above that of its peers or a broad index of stocks such as the S&P 500. Something could occur to heighten this risk to include the untimely death of a member of senior…
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