Types of Investing Risk, Explained

How To Understand Different Types of Investment Risk (And What They Mean) 

Managing risk is one of the most important concepts to understand when investing, whether as an individual or an institution. However, risk doesn’t come from just one place, and there are various types of risks an investor must consider when determining an investment's risk profile. 

In this article, we’ll review well-recognized and secondary forms of investing risk, which are still vital but may not be considered by many investors. 

We should note that this article focuses on the risk profiles of individual investments (with a focus on stocks) and does not focus on the risks of individual investors-- such as retirees who may face sequence of returns risk or longevity risk. 

That being said, some of the significant types of investing risks to consider include: 

• Interest Rate Risk 

• Industry Risk

• Customer Risk

• Supply Chain Risk

• Systemic Risk

• Regulatory Risk

• Pricing Power Risk

• Inflation Risk 

• Reputational Risk 

• Currency Risk

• Commodity Risk

• Geopolitical Risk 

• Management Risk

• Tech Risk 

• Cultural Risk 

It’s also important to realize that companies and entire industries generally face various risks at once, and certain risks can have a compounding effect, meaning that two or more risks together can lead to a significantly worse financial outcome than either alone. 

Risk cannot be eliminated when investing, but it can be limited, especially at the portfolio level. For example, ensuring that a large portion of a portfolio does not consist of investments that face the same type of risk is essential. This can be done by diversifying across a variety of industries, as well as diversifying between stocks, bonds, and other asset classes. 

Interest Rate Risk 

Interest rate risk refers to the risk a business can incur when interest rates rise. Businesses most sensitive to interest rate risk include those that utilize lots of debt (like real estate companies) and businesses that provide credit (like banks). In addition, businesses whose core customers utilize debt to make purchases, such as mortgage lenders or certain manufacturers, are also sensitive to interest rate risk, as their clients may no longer be able to pay for their goods and services. 

When looking at whether interest rate risk could directly impact a business’s balance sheet and viability, you can look at various metrics, such as debt to equity ratio. You can also go deeper by examining the type of debt they’ve issued. For example, a business with fixed-rate, long-term bonds will not be nearly as sensitive to interest rate risk as a company with short-term or variable-rate bonds or other variable-rate debt obligations. 

For many businesses, certain liabilities, such as unpaid pension obligations or warranties, may be listed as off-balance-sheet expenses, but, in many ways, they still count as debt to evaluate a company's financial position. Therefore, careful investors should take these liabilities-- and not just traditional liabilities (like bonds, accounts payable, or bank loans) into account.  

Industry Risk

It may sound obvious, but different industries face significantly different risks. These are usually variations of other types of risks discussed in this article. For example, pharmaceutical companies may face regulatory risks that could decrease drug prices or impact insurance reimbursements, patent expirations, and lawsuits from harmful or defective drugs. Likewise, energy companies could face competition from alternative energy sources, climate-change-related regulations, or geopolitical risks that may prevent them from obtaining resources from specific countries or regions. 

Customer Risk

Businesses can face significant risk if they lose customers or if customers significantly reduce their spending on a product or service. Businesses that rely on only a few customers could face considerable declines in cash flow if a single customer stops utilizing their products or services, mainly if that customer represents a large portion of their revenue. For businesses with a high degree of customer concentration, it may be ideal to review the financial position of the company you want to invest in and that business’s customers. For instance, even if a company is currently in a great financial position if its corporate customers are facing financial difficulties, this could be a ticking time bomb that could derail that business’s profitability and even its solvency. 

For businesses with a large pool of customers, such as consumer businesses, customer risk is usually a variation of other common risks, such as competition from different companies or lousy management that leads to poor customer service or undesirable price increases. 

Supply Chain Risk

Supply chain risk is the risk that comes from a company’s suppliers. This is generally most important for capital-intensive companies that create or distribute physical products or commodities and is less critical for companies in the software or service industry, which don’t rely on physical inputs. For example, homebuilders rely highly on products like concrete, steel, and lumber, while energy companies may depend highly on chemical products. Therefore, it's essential to look at what types of supply inputs a company requires to continue providing its products or services, how many suppliers it has, and the financial condition of these suppliers. 

Logistics issues, which can result from increased fuel prices, as well as geopolitical issues (such as wars or piracy), which may cause problems with shipping, can also significantly add to supply chain risk for industries that rely on products shipped internationally. Therefore, if a business relies on only a few key suppliers to generate profits, and the suppliers themselves have high risk profiles, it may be unwise to consider investing in such a business. 

Systemic Risk

According to the CFA Institute: “Systemic risk refers to the risk of a breakdown of an entire system rather than simply the failure of individual parts.” One of the most often cited examples of systemic risk was the subprime mortgage crisis and the resulting market crash of 2008, which nearly led to the failure of the U.S. financial system. The 2008 crisis led to the failure of Lehman Brothers, which was so intertwined with the U.S. and global financial system that its failure led to a credit freeze, making it nearly impossible for companies and consumers to get loans. While Lehman was not bailed out, the U.S. government decided to bail out the insurance company AIG, which had many assets tied up in complex credit default swaps. Many believe this $180 billion bailout helped rescue the American and global financial system, preventing a broader collapse. 

Systemic risk can be challenging to predict and even harder to protect against. Since systemic risk can impact stocks and bonds, even reducing a portfolio’s equity exposure may not fully guard against systemic risk. However, if an investor predicts that a market will soon suffer a meltdown as a result of systemic risk, they can increase their portfolio’s cash position in an attempt to reduce their exposure to both stocks and bonds. 

Regulatory Risk

Increased or decreased regulation (and sometimes both) of an industry can significantly threaten a business’s profitability. For example, increased regulations impacting the price of pharmaceuticals and insurance reimbursements could affect the pricing power and profit margins of pharma companies, while (though unlikely) significantly decreased regulation could make it easier to allow smaller firms to develop drugs that could compete with established brands. 

Another form of regulatory risk that can impact firms is patents and expirations. Many companies hold valuable patents, and when these expire, this can lead to significantly increased competition from competitors. Changes to patent law can often impact these developments further, which is why its important to keep your eye on businesses that derive a significant amount of their value from patented products or technologies. 

Antitrust regulations may also impact businesses seen as having a monopoly or near-monopoly on an industry. For example, due to its near-monopoly on internet search advertising, Google has recently been hit by multiple anti-trust lawsuits, including from the EU and the U.S. Department of Justice. Some fear that this could lead Google to be split into various individual companies. However, antitrust lawsuits that lead to business split-ups may not always be a bad thing for investors; for example, many of the separate oil firms that resulted from the break up of Standard Oil performed exceptionally well in the decades after they split apart, leading to excellent returns for most investors, and, if Google does get broken up, it may be more valuable as multiple businesses rather than as a single tech conglomerate. 

Pricing Power Risk

Pricing power risk refers to the risk that competitors can undercut the price of a company’s products or services with lower-cost products. Sometimes, this can lead to price wars between companies with similar products, such as the “Cola Wars” between Coke and Pepsi. This significantly reduced prices for both products, hurting the bottom line of both companies. Therefore, it’s essential to see if a company’s product or service can easily be replaced or if consumers may not be willing to pay the current price for a product in times of economic turbulence. 

Inflation Risk 

Inflation can pose a significant risk to businesses, in most cases, due to drops in consumer spending and reductions in spending power. Inflation can have the most severe impacts on consumer discretionary businesses, such as clothes and cars, as these purchases can be deferred by months or years and have much less effect on companies that provide products or services that are needed even if consumer discretionary income drops significantly. 

In addition, inflation often leads to central banks, like the U.S. Federal Reserve, increasing interest rates to reduce inflation. This lack of credit can impact the ability of businesses to gain access to low-cost capital. It can also further reduce consumer spending as interest rates for consumer loans like mortgages and credit cards increase. 

Reputational Risk 

It’s no secret that a company’s reputation can significantly impact its stock price in the short and long term. While a company selling much-needed products, such as large pharma companies, may be able to weather short-term reputational hits such as class-action lawsuits, other companies, particularly companies that sell discretionary products, may not be so lucky. 

Other situations may be more grey-- such as Boeing’s recent quality control issues that have grounded many of their planes. Boeing supplies many of the world’s passenger jets and is a principal U.S. defense contractor, so its products are in high demand, and it has significant competitive advantages. However, it's unclear whether Boeing’s quality issues are a blip in the radar or a sign of deeper management and engineering problems that could impact the company’s profitability and stock price for years.  

Currency Risk

Currency risk occurs when changes in currency exchange rates negatively impact a company’s profitability. This is typically a greater risk for global companies operating in various countries, especially when they have significant business interests or a significant portion of profits attributed to countries with high inflation and unstable currencies. While many companies hedge their currency risk by regularly converting relatively unstable currencies to U.S. dollars regularly, some companies may keep large cash balances in foreign currencies to avoid immediately paying U.S. taxes on that money, so if foreign exchange rates fluctuate significantly, this could substantially reduce the value of their cash assets. 

Therefore, when looking at currency risk, it's important to understand where a company does business and how much of its cash reserves are kept in currencies that could see a significant reduction in value. 

Commodity Risk

Commodity risk can be considered a variant of supply chain risk, but since commodity prices can be highly volatile, it deserves its own section in this article. Before investing in a business, you’ll want to determine how much it relies on commodities and if it can pass commodity price increases on to consumers without significantly reducing cash flows or losing market share. For example, while a well-established and generally profitable company, Hershey’s faces significant risk from the volatility of cocoa prices, which can be impacted by geopolitical factors, mainly since a considerable percentage of the cocoa they source is farmed in Africa, a region well-known for its geopolitical instability. 

Companies reliant on commodities typically hedge their commodity risk by locking in commodity prices via futures contracts. However, these contracts are generally short-term, so long-term increases in a commodity's cost can still significantly impact a company’s profitability, no matter how effective their hedging strategy is. 

Geopolitical Risk 

Geopolitical risk results from conflicts and issues involving governments and can significantly impact many businesses, including those with a global footprint. For example, in 2022, the S&P 500 fell significantly, primarily due to the Russia-Ukraine War, which led to a spike in oil and natural gas prices, significantly increased inflation, disrupted international shipping, and reduced consumer demand for various goods and services. 

Future conflicts and geopolitical issues that could impact businesses include disputes between the U.S. and China, which could significantly affect U.S. and global companies that sell a significant portion of their goods and services to the Chinese market (such as Tesla), as well as companies that manufacture goods or source commodities from China, such as clothing and electronics manufacturers or their clients (like Apple).  

Management Risk

While great managers can save a company in distress, bad managers can ruin even the most outstanding businesses. Warren Buffet famously said, “You should invest in a business that even a fool can run because someday a fool will.” However, even Buffet’s famous quote has its limits. When looking at management risk, its important to look at the background of a company’s CEO and management team. A few questions to ask might include:

• How long has the CEO held their role? 

• Was the CEO promoted internally or did they come from another company? 

• If the CEO recently came from another business, was it relatively similar to the company they currently lead? 

• How honest is the management? 

• Does the management misrepresent earnings or create the expectation that future earnings will be significantly higher than what a reasonable investor could expect? 

• Has the company been involved in any accounting fraud or scandals? 

• How does the company treat its employees?

• How does the company treat its suppliers? 

Tech Risk

If new technologies can easily replace a company’s product or service, or if emerging technologies could seriously erode its competitive advantage, the business could face significant technological risk. For example, Blockbuster failed to anticipate the success of online streaming services like Netflix, and it paid the price. While it eventually launched a streaming service, it was too little, too late, and, as of 2024, only one Blockbuster location remains standing. While not quite as profitable as it once was, Netflix remains a well-respected company and, as of late 2024, had a market cap of over $285 billion, making it the world’s largest entertainment company by market cap. Similarly, Amazon latched onto the video streaming bandwagon and reaped substantial profits from its Amazon Prime streaming service. 

Other examples of tech innovations disrupting traditional businesses include the rise of online retail, which, in most cases, has decimated the profitability of conventional, mass-market,  brick-and-mortar retailers, with the only exceptions being the sellers of extremely high-end luxury products (like Louis Vuitton and Hermes), and very low-end retailers, such as dollar stores. 

It's challenging to anticipate technological changes, and it's hard to say how innovations like AI will impact the valuation of global business, though companies that provide low-skilled services may see their competitive advantage eroded by AI; however, if these companies can take advantage of AI to reduce labor costs or increase efficiency, they may benefit from AI innovations. However, other companies may be less impacted by AI, such as companies in more traditional industries, such as consumer goods, pharmaceuticals, and industrial products, as machines can’t replace these products-- however clever they may be. 

However, it may be wise to avoid investing in a business when you see a company (or even a total industry) being delegated to the dustbin due to technological innovations. 

Cultural Risk

Most investors wouldn’t list cultural risk as a core investment risk factor, but it can impact certain businesses. This is particularly the case for discretionary products, such as fashion brands. For example, while Abercrombie's clothes were all the rage in the early 2000s and early 2010s, their styles fell out of fashion in subsequent years, making the company significantly less profitable than it used to be. While Abercrombie clothes have had a recent cultural comeback, and the stock price has increased rapidly over the last few years, investors would have had to weather many years of low stock prices had they invested in Abercrombie over the long run. 

Likewise, with the increasing percentage of the U.S. population that identifies as irreligious, atheist, or agnostic, traditional burials have fallen out of fashion and have often been replaced with cremation, leading to significant financial losses for the funeral home industry. 

It can be difficult or impossible to predict cultural trends in advance. However, if you can sense that a company or industry relies on trends to make its profits rather than core consumer or business needs, it may be wise to limit or eliminate your exposure to that company or industry.