Risk and Asset Allocation I: Types of Risks

Diversifying offsets the risk of a type of investment with other different investments. The market rewards idiosyncratic risks

Risk and Asset Allocation I: Types of Risks

Risk is the chance/ possibility of not getting the expected profit or(sometimes) even a loss associated with taking a financial decision.

As a general thumb rule; The higher the risk the higher the return.

When you invest there is always this possibility of losing your money. There is typically no “safe” or “100% guarantee/risk-free”. If you see this RUN and don’t look back. There is always a scenario of loss in any investment asset.

In investing, risks can be broadly classified into:

  • Systematic Risk: These are risks that affect all investment assets. This means once you invest, you already have taken these risks. Unfortunately, they aren’t diversifiable. No matter the number of investment assets you have, there are always there. These risks include Inflation, interest rate, market/political instability, etc.
  • Non-systematic Risk or Idiosyncratic: These are risks that are sector or industry-specific. They do not affect all investments. This type of risk can be managed, unlike systematic risks.

Since they differ from sector to sector or firm to firm, they can be reduced by DIVERSIFYING across asset classes, sectors and industries, and even countries.

Diversifying offsets the risk of a type of investment with other different investments.

The market doesn’t reward you for non-idiosyncratic risks, it rewards idiosyncratic risks

Measure of Risk

Risk measures are statistical measures that are historical predictors of investment risk and volatility. They are used to determine how risky an investment is. They can be used in combination or individually. There are five principal measures.

  • Alpha
  • Beta
  • Standard deviation
  • R-squared and
  • Sharpe Ratio
Pressure gauge on a steamship.
Photo by Pete Nuij / Unsplash

Asset class according to their risk level starting from the least

  • T-bills
  • Money Market securities
  • Long term debt
  • Stocks
  • Foreign investments, Real estate, options, futures contract etc.
The higher the risk the higher the return.