The Risks of Investing

My father-in-law’s late business partner always said, “The world is in the hands of the risk takers.”

Risk, like volatility , is another one of those investment terms that tend to get thrown around very loosely. Personally, I believe that risk, like beauty, is in the eyes of the beholder. In this edition of “The Finance Professor,” I will explain several basic forms of risk to help prepare you for the next lesson, which will cover how you can manage risk.

 

What Is Risk?

Risk is not a single element but rather a collection of hazards that when taken together expose an investor to adverse consequences. Risk plays a role in many facets of our lives, including our health, our career, our investments and several others. (I will focus in on the investment risk and leave the other risks to other experts.) Every person has his or her own level of risk tolerance. In investment terms, increased levels of risk usually imply greater potential for financial benefit. We refer to this as the risk/reward relationship. There is good risk and there is bad risk. It’s kind of like cholesterol (LDL vs. HDL). You must factor out the bad risk and focus on the good risk. When you’re able to make this separation, you can ensure that the level of risk that you assume falls within your comfort zone. As an individual investor, some basic risks you should be cognizant of before and after you make any investment decision are:

  • Market risk
  • Systemic risk
  • Interest rate risk
  • Credit risk
  • Counterparty risk
  • Sovereign risk
  • Estimation risk
  • Extrapolation risk

 

Market risk:

This form of risk represents your exposure to the overall market. For example, if the S&P 500 were to go up and your portfolio would also rise, then you have market risk to that particular index. What gives rise to market risk is something that we call beta. Beta represents a stock or portfolio’s correlation to an index. (For those readers more statistically astute, beta is the correlation coefficient derived when performing a regression between a stock/portfolio and an index.) In other words, for every 1% movement in the index, your stock or portfolio would rise X%. Beta is typically displayed as a unitized number. Thus, a beta of 1.5 means that for every 1% move in the index, your investments would increase 1.5 times 1% or 1.5%. While I used the S&P 500 as an example of the market portfolio, your individual portfolio might more closely track the Dow Jones Industrial Average, Nasdaq 100 or Nikkei 225.

 

Systemic risk:

This risk is associated with a complete breakdown of an economy, market or segment thereof. Examples of systemic risk include the Great Depression in 1929, the Arab oil embargo in the 1970s, the Latin American debt crisis of the mid-1990s, the Russian financial crisis in the late 1990s, and the Asian contagion in the late 1990s. A systemic risk is the most formidable danger posed to an investor because of the difficulty or inability to predict its occurrence and manage its outcome.

 

Interest rate risk:

Exposure to all or part of the term structure or nature of interest rates will create financial danger to an investor. There are two aspects to these risks. First is the term structure. Interest rates are quoted based on time to maturity. Yield will vary by maturities, thus creating what we call the yield curve. The second facet of interest rates is the fixed and floating aspect of those rates. Fixed-rate investments will yield the same rate for the entire duration of the investment. Floating or variable interest rates will fluctuate over time. Interest rate risk will affect both lenders (bond buyers or mortgagees) and borrowers (such as mortgagers). Finally, while interest rate risk has a direct impact on fixed-income investors, there is only a secondary effect on stock investors.

 

Credit risk:

Not all companies have an equal ability to repay their debt. Credit worthiness is quantified by credit rating agencies such as Moody’s , Standard and Poor’s and Fitch. Each agency will carefully review a debtor’s balance sheet, cash flow, income statement, contracts and debt covenants to ascertain that company’s ability to repay its debt. Typically, the highest credit rating of AAA is given to the most creditworthy companies. This is followed by AA then A then BBB and so on. There are some variations between credit agencies such as use of smaller case letters or minus signs. There is a further delineation between investment grade and noninvestment grade. Investment grade is typically BBB-minus or better, and non-investment grade is typically BB-plus or worse.