Principal Risk

A conservative investor wants to at least get back the original investment.

There are 10 sources of principal risk, the risk of loss of principal

  1. business
  2. currency (exchange rate)
  3. default (credit)
  4. financial
  5. inflation (interest rates)
  6. leverage
  7. liquidity
  8. market ("systematic")
  9. marketability
  10. reinvestment


  • beyond the control of the business (e.g., competition, new products)
  • declining company sales &/or profitability
  • hurts shareholders

Currency (exchange rate)

  • changes in foreign exchange rates reduce returns
  • when investments denominated in a foreign currency
    • e.g., GE shares on NYSE: exchange loss if the US dollar falls relative to Canadian dollar
  • cannot reduce by diversifying

Default (credit)

  • company may be unable to make contractual payments to lenders
  • interest, dividends or principal may not be paid or repaid as scheduled


  • company may have severe financial problems
    • e.g., collapse of Enron
  • lenders and shareholders can lose

Inflation (interest rates)

  • increases in inflation caused real returns to decrease
  • for fixed income investments like bonds
    • e.g., 10% bond sold in 12% environment → loss of principal
  • marketable but not redeemable


  • if return on investment < cost of borrowing
  • e.g., borrowing at 7% to earn 10%, but only earned 6%


  • difficulty in buying/selling investments when you want (or at a fair price)
  • ease of cashing investment with minimum principal risk
    • e.g., CSB highly liquid but 5-year GIC may be illiquid (and unmarketable)

Market ("systematic")

  • all assets in the class (e.g., stocks or bonds) could decline
  • negative effect of economy-wide factors on market psychology and investor attitudes
    • e.g., changes in interest rates, political events, real economic growth
  • can't reduce by diversifying
  • non-systematic risk: stock or sector moves against (contrary to) the market
      • can reduce by diversifying (e.g., with index fund)


  • ease of selling an investment to another party
  • e.g., common shares (but not redeemable)


  • for fixed income investments like term deposits, GICs, bonds
  • if interest rates fall, must reinvest at lower interest rates

PS Network

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