Risk and return-advantage types
Risk in the investment is the potential to loose money. Risk is paired with advantage: investors promised a bigger return will tolerate some risk.
Credit default risk
This risk is particularly relevant for bonds. This is the risk of businesses not repaying their loans.
The advantage is that riskier bonds yield bigger returns.
Credit rating agencies
Sometimes, the ultimate owners of bonds sometimes do not have a clear idea about the risk involved.
Agencies such as Moody’s evaluate various investment options (including government bonds) and assign a letter grade indicating the risk involved; AAA being the best. Credit rating assigned to Japan actually means Japanese government bonds.
Trustworthiness
These ratings are highly trusted by investors who manage global savings. They are also trusted by governments, which require firms which hold possibly big liabilities (insurance firms, banks) to invest a certain fraction of their capital in highly rated bonds/ loans.
But, their evaluation methodology is not flawless. For example, before the 2008 sub-prime mortgage crisis, they wrongly rated US mortgage-backed securities as being a safe investment- because they used the wrong historical data pertaining to mortgages with better guarantees, and because they assumed that real estate prices will continue to increase.
Interest rate increase risk
Suppose that the interest rate on government bonds increases (perhaps due to investor concerns about budget deficits or due to the action of the federal bank to combat inflation). Then, bond prices, especially of long term bonds, fall in response to the decreased demand. People can simply invest capital in the newly high-yielding government bonds or banks: so that for existing bonds to compete with them in yield, they have to fall in value.
Concentration risk
Investing in a small number of businesses is considerably riskier than investing in a diverse variety of businesses. But, focusing on a particular fast growing business segment promises higher returns.
’Exposure’ to a variety of businesses (diversity in investment) reduces risk.
Underlying security capitalization
In case of investment funds, this can be measured in terms of the capitalization of the underlying securities.
The safety of a fund is proportional to the market capitalization of the component stocks (i.e: what portion of the economy it represents.)
For example, S&P 100 tracks 100 important companies in various sectors, S&P 500 tracks 500 companies. The prices of these index funds form a way of tracking the health of the economy - Eg NSE, BSE in India, Dow Jones etc..
Small business risk
Aka small capitalization/ size risk. Small businesses constitute riskier investments - they are not as entrenched as bigger businesses which may out-compete them; and they may fail due to short-term reasons which would not affect larger companies with their greater access to resources.
Larger businesses are better able to benefit from faster growth in emerging markets.
Foreign currency risk
If the returns from a business/ security is in a foreign currency, that currency may appreciate in value relative to the investor’s currency, leading to lower value reaching the investor than initially expected.
Emerging markets risk
There is a cost of lower skilled work-force, corruption, worse regulation and bad infrastructure.
Emerging markets often have the advantage of higher growth.
Geographical risk
Certain geographical regions have more socio-political instability than others - causing businesses in those regions to be more susceptible to disruptions.
Leverage risk
Businesses which use leverage to conduct transactions are especially vulnerable to short term losses.
Risk measures
One component of this is to observe past performance: though it is not a guarantee of future returns.
Correlation
The correlation of the value of the security with the relevant economy / sector - perhaps measured using the value of the corresponding index - is informative. An investment whose return is not highly correlated with the relevant economy / sector brings diversity to the portfolio, and helps reduce risk.
_R_2 is a common correlation measure - with values ranging [0, 1].
Curve based
The ratio of past upticks to downticks, yield in past years (especially bad years) help compare risk.
Volatility
Also, the standard deviation in stock-prices (together with highs and lows) in a certain time period describes volatility. Volatility, if it does not co-occur with monotonic increase, indicates risk in short term trading.