Risk and Return
Investment Risks
Most investments carry some amount of risk with them. The overall risk our investments face is known as portfolio risk. Portfolio risk is comprised of two main elements; unsystematic risk and systematic risk.
Systematic Risks
Outlined below are several systematic risks an investor faces.
- Market-volatility risk
- Inflation risk
- Business-cycle risk
- Liquidity risk
- Interest rate risk
- Marketability risk
Market-volatility risk 
The market as a whole is up at times and down at others. If several companies in a related field are doing poorly, that could bring down the value of other companies in the same field just by that association alone.
Inflation risk
This is the risk that your money will lose buying power to price increases; also known as inflation. In essence this means that a dollar next year will buy you slightly less than what it will buy you today. Long-term inflation in the United States has averaged 3.0% annually from 1926-2007 (Ibbotson 2008). However there have been periods when inflation has been in the double digits!
Business cycle risk
You may have heard terms like recession or expansion on the news. In general the economy has periods where it is growing and periods when it does not. The exact duration of these periods is not preset and will be affected by many things. Most businesses are affected by these general movements in the economy. Some businesses are less affected by these movements; for example regardless of the business cycle people are going to need to pay for certain expenses that cannot be cut, diapers is one example, utilities are another. Their value may be less sensitive to changes in the business cycle.
Liquidity risk
Liquidity is the speed and ease at which an asset can be converted into cash. Money in a savings account or checking account is extremely liquid as you can go to your bank or an ATM and withdraw the money instantaneously. Stocks and bonds are less liquid than money in a savings or checking account. You can sell your stocks and bonds in one day but it may take several days before you have access to the cash from the sale. Further, since prices fluctuate, you may lose money if you need to sell quickly. Real estate is not liquid as it may take months or even years to sell property in order to get cash.
Interest rate risk
As with the overall business cycle, interest rates fluctuate. Typically if interest rates increase, the value of stocks and bonds decreases. If interest rates decrease, the value of stocks and bonds increase. In both situations however, interest rate risk is more closely associated with bonds than stocks.
Marketability risk
This risk occurs if you have to sell a particular asset quickly, you may not get the market price for that asset. An easily understood example would be if you needed to sell your home in a hurry. In order to do so you would probably have to lower the asking price considerably. If you were not in such a hurry to sell, you could afford to wait longer and ask for a fair market price.
Unsystematic Risk
Unsystematic risk is unique to an industry or more often to a few or even one company. For example think of a company with a new product. If it fails, this will harm only that company or a select few. However it is unlikely to affect the market as a whole. In other words, companies may do well or not for any number of reasons. While there are common risks companies all face such as interest rate risk, there are other sources of risk that may be unique to the company.
Since any one investment may be up or down, it is important to have a bundle of them. With the number of companies to consider, does it seem wise to invest in only one of them or several of them? If you invest in only one of them you better hope that it does well or you will lose money. If you invest in several companies, some of them may do poorly and lose you money in any given year but several of them may also do really well to gain you money.
The utilization of multiple assets to reduce or eliminate unsystematic risk is referred to as Diversification. In other words, do not put all of your eggs (money) into one basket (single company). By having assets not too closely related, some may be up while others are down.
The easiest way for most of us to diversify is not to buy individual stocks but instead to invest in a portfolio of stocks through mutual funds. Mutual funds are essentially a basket of individual stocks, bonds, or other investment assets; and we just invest in that basket. There may be hundreds of stocks represented in a single mutual fund. Several studies have been conducted stating that you can eliminate unsystematic risk by investing in as little as 15 stocks. The diagram below clearly shows this. As you add more stocks to your portfolio, your unsystematic risk decreses. In addition, exach transaction typically has a fee so investing in individual stocks, rather than mutual, can prove quite costly for the small investor.
Diversification site: Mayo, H. (2006). Basic Investments (1e). South-Western