By now, you already know that market risk is the term used to describe the risks that occur as a result of changes in the markets. Market risks are usually large-scale and affect many different assets and asset classes. Therefore, investors generally believe that market risks are difficult to diversify away from, because they likely affect many of the assets an investor chooses, even within a well-diversified portfolio.
However, not all kinds of risk are inescapable in this way. The second main branch of risk, called specific risk, can be mitigated by diversification! Specific risks are typically defined as the risks that investors take which are directly tied to a company or an industry. Because these risks are relatively small-scale compared to risks that affect entire markets, investors generally try to gauge specific risks by looking at a company’s products or past figures. Then, by better understanding these specific risks in potential investment options, investors can try to pick less risky investments or even fill their portfolios with investments that carry different levels of risk, thereby reducing their portfolio’s risk as a whole.
Further, just as we saw when we evaluated market risks, there are many different kinds of risk possibilities that fall under the umbrella of specific risk. For this reason, we have compiled a list of the top five most common specific risks that investors should be aware of:
1. Operational Risk
This term refers to risks within a company’s business process that might occur from human errors. Obviously, these operational risks might change from company to company and between different industries, due to the demands and regulations that each entity faces.
2. Financial Risk
Also called credit risk, this risk refers to any changes in the capital structure of an organization that might compromise the ways in which projects are funded. Basically, when considering financial risk, investors look at the ways in which a company funds its important projects and evaluates the stability of those finances.
3. Business Risk
This kind of risk is also called liquidity risk, and it comes from the actions of purchasing and selling assets within a business. Many times, companies both own or need assets that are essential to their business’s proper functioning. Therefore, the values at which these assets are bought and sold can be imperative to a company’s budgeting and financial planning.
4. Competitive Risk
This kind of risk refers to the idea that companies may face new or very close competitors within their markets. Any kind of external competition can change the way in which a company operates by creating the need for both more resources and more sales. Therefore, the presence of upcoming competition may change the way that an investor views a company’s stability.
5. Relative Risk
Finally, this term is used when investors evaluate the risks at different levels of a company’s business functions. If one function of a business looks very risky, but others do not, an investor may want to calculate the importance of the risky area as a sum of all of the company’s procedures.
While this list is not an exhaustive list of all of the kinds of specific risks that might face different industries and companies, we hope it sheds some light on the kinds of things that investors typically look for when evaluating a company’s risk profile. Further, because specific risks can be diversified away, it is always good to know the different kinds of risks to look out for!