Understanding Risk

Balancing risk

Types of risk

For higher investment yields you have to be prepared to take some kind of risk. In particular, you should be aware of two kinds of risk, Market risk and Unique risk.

Market risk

Have you ever noticed the way the values of individual stocks often tend to move in the same general direction as the overall market index? It is unusual for individual stocks to move markedly against the movement of the FTSE-100. This is because they are all driven by the same factors - inflation, interest rates, GNP figures - that affect the overall health of the economy. This is market risk.

Unique risk

Unique risk is specific to a particular stock.

Take, for example, DaimlerChrysler stock. Production disruption caused by a strike would be a source of unique risk in that it would only affect DaimlerChrysler.

Other sources of unique risk include:

• mistakes by company management.
• new inventions by a competing company.
• lawsuits.

Diversification

When you invest in the stock market you face both market risk and unique risk. The good news is that you can mitigate unique risk by taking a diversified approach to investing.

Diversification means spreading your money over a number of investments in order to reduce unique risks associated with individual investments. The more stocks you add to your portfolio (your collection of individual investments) the more unique risk you eliminate and the smoother your overall returns become.

Asset allocation

Unfortunately, diversifying your portfolio with more stocks will not eliminate market risk.

You can reduce this risk, however, by switching your money into less risky investments such as government bonds or savings bonds but you will have to settle for lower returns.