Introduction to Financial Risk
In investing, financial risk is the variability of the actual return generated by an investment relative to what the investor expected. As an example, financial risk is represented by a stock that is expected to return 5% but instead only returns 2%. Only risk-free assets give returns perfectly equal to expected returns. The risks of an asset are measured by its variance and standard deviation.
Types of financial risk
The two main categories of the cause of financial risk are:
- Firm-specific risk (unsystematic, affecting a single firm or a small group of companies)
- Market risk (systematic, affecting all firms in the market)
Firm-specific vs market-specific financial risk
Firm-specific financial risks can be subdivided into:
- Project risk – The risks that a firm might’ve misjudged its product demand
- Competitive risk – Risks arising from the impact of marketplace competition
- Sector risk – Risks affecting the entire sector and restricted to that sector
Market risk is felt, in varying degrees, throughout the economy. Any large-scale investment risks are considered market risks.
Putting all of one’s capital into a single investment exposes the entire portfolio to the financial risk of that investment. Diversifying, or allocating capital across different assets, helps reduce exposure to firm-specific risk.
This concept is illustrated by the notion of “putting all of one’s eggs (capital) into one basket (investment)”. Dropping the one basket breaks all the eggs. Putting eggs into multiple different baskets reduces the chance of breaking all the eggs.
The concept is the same in investing. Since firm-specific risks can be diversified away, they are also known as diversifiable risks.
Holding an appropriate number of assets within a portfolio, with firm-specific risks diversified away, does not make a portfolio risk-free. The portfolio is still affected by the overall market risk or non-diversifiable/systematic/non-specific risks.
- Market risk is interchangeably used with systematic risk, non-specific risk, non-diversifiable risk
- Firm-specific risk is interchangeably used with unsystematic risk, specific risk, and diversifiable risk.
Risk and the cost of equity
An investor will only invest in a stock if they are sufficiently compensated for the financial risk with additional potential returns (above the risk-free rate). The additional return is otherwise known as the cost of capital. This cost of capital number can be estimated by:
The CAPM is the most commonly used method.
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