What risks will you encounter in investing? Risk can be a rather complicated matter we need to be fully prepared for. As wise words from a veteran businessman remind us, "The world belongs to risk-takers."
So, what is the true nature of risk? Along with volatility, risk is among those words or concepts often taken for granted or misunderstood by many people.
Yet, like beauty, risk is in the eyes of the beholder. In order to effectively manage risk, we must define and classify risk into manageable sizes.
Risk is fundamentally a multi-dimensional phenomenon consisting of adverse possibilities which an investor is bound to encounter. It affects many aspects of human life: our well-being, our profession, our family, our investments and many more. For our purpose, we limit our discussion to investment risks.
Different individuals will have different levels of risk tolerance. In investing, the higher the risks involved, the greater the potential for financial gain. This is the risk/reward relationship. Moreover, good risks are as common as bad risks. Like wine, some friends are good; some are bad. Hence, the trick is to avoid the bad risk and deal with the good risk. Once you master this move, you can maximize your financial potential as you will remain where you can control the hazards along the way.
For any investor, the following fundamental pitfalls should be considered prior to making any investment decision and afterward:
• Market risk
• Systemic risk
• Interest rate risk
• Credit risk
• Counterparty risk
• Sovereign risk
• Estimation risks
• Extrapolation risk
Market risk:
This type of risk involves the inherent hazards which affect all investors engaged in the market. For instance, if the S&P 500 increases then your portfolio will also go up and an investor will have market risk relative to that index.
Market risk arises due to a phenomenon called beta, which is a stock or portfolio's correlation to an index. (For readers who want a statistical definition, beta is the correlation coefficient computed based on a regression between a stock/portfolio and an index.)
In short, for a 1% movement in the index, your stock or portfolio moves up X%. Beta is commonly presented as a unitized number. Hence, a beta of 1.5 signifies that for each 1% movement of the index, your investments would go up 1.5 x 1%, or 1.5%. This rule might be applied to other portfolios which might correlate closely with Nikkei 225, the Dow Jones Industrial Average or Nasdaq 100.
Systemic risk:
This type of risk relates to the complete meltdown of an economy, market or a portion of it. Historical instances of systemic risk include the 1929 Great Depression, the Arab oil embargo in the 1970s, the Latin American debt crisis of the mid-1990s, the Asian contagion and the Russian financial crises which occurred in the late 1990s.
Considered the most potent hazard to investors, systemic risks are hard to predict and manage for any individual or corporate investor.
Interest rate risk:
This type of risk results from exposure to any part or the entire term structure or characteristics of interest rates, adversely affecting any investor. Two factors influence this type of risk. First, term structure determines the maturity time for interest rates. Based on maturities, investment gains will vary accordingly, producing a portfolio’s yield curve.
The second factor pertaining to interest rates involves their fixed and floating nature. Fixed-rate investments will produce the same rate for the whole investment period. Floating or variable interest rates will vary over time.
Those who are subject to interest rate risk include lenders (mortgagees or bond buyers) as well as borrowers (mortgagers). Lastly, whereas interest rate risk may directly affect fixed-income investors, it can only indirectly impact stock investors.
Credit risk:
Companies do not have equal capabilities to repay their debts. Level of credit worthiness is measured by credit-rating groups such as Moody's, Fitch and Standard and Poor's. Every one of these will evaluate closely a debtor's balance sheet, income statement, cash flow, contracts and debt agreements to determine a company's capability to pay back its existing debt.
The highest credit rating of AAA is usually given to the most creditworthy firms. Next in line is AA, followed by A and BBB, etc. Some credit agencies have different ways of rating, using lower case letters or minus signs. Moreover, differentiation between investment grade and noninvestment grade is also designated accordingly -- investment grade being BBB-minus or better, and non-investment grade as BB-plus or lower.
While credit risk is measured subjectively in such ratings, a certain firm's rating may be either upgraded or downgraded. Companies are constantly under "credit watch." Any investor must include this fact as part of one’s credit risk management. Some investors are not allowed to secure non-investment-grade debt, and being moved from investment grade to non-investment grade may lead to portfolio liquidation and, therefore, adversely affect one's personal credit risk tolerance.
Counterparty risk:
When you enter into a deal with another party, you not only have to consider the capability of that party to pay. You also need to evaluate that party's willingness or ability to follow the requirements of the contract. Although credit risk and counterparty risk may appear the same, they expose investors to varying risks.
Credit risk fully hinges upon repayment of debt, while counterparty risk involves the performance of contract obligations. To apply in a specific case: If you plan to invest in renovating your house which includes fixing a leaking roof and the contractor refuses to fix it, you are exposed to counterparty risk as the contractor neglects a contract requirement. You can charge the contractor in court and upon getting a decision you can add credit risk to the equation, since you now become practically an unsecured creditor of the contractor.
Sovereign risk:
Many sovereign countries issue their own government debt which is most probably unsecured and which investors have ostensibly no ability to collect on. Classic cases of this type of risk include sovereign nations issuing worthless debt, for instance, the Weimar Republic prior to Hitler's ascendancy to power and Argentina when it defaulted on its debt in 2001-02.
Estimation risk:
A previous lesson covered earnings releases and earnings calls. We said that analysts derive EPS and income estimates, which they lump into consensus estimates as being mere projections of what each company will finally report.
Likewise, firms will offer their own guidance, offering management's projection of the company’s performance based on particular reporting parameters. Often, the risk lies on the fact that such figures are either too low or too low.
In a recent case, Men's Wearhouse informed investors one month prior to its earnings release that EPS for 2007’s first quarter will be at the low end of its guidance, leading to MW stock being sold off due to that revelation. When the company reported its actual first-quarter performance, EPS stood at the high end of its initial guidance. Many people were surprised and the firm’s stock rose almost 10% on the same day.
Extrapolation risk:
This risk is related to the use of historical trends to project future prices. For instance, if you see a stock growing 20% each year for the past five years, by extrapolating, you will expect that the stock will continue to grow by 20% the following year. You then buy the stock. But history will not guarantee that the stock will continue to rise 20% each year; most probably, it could decline in the following year.
This mistake is committed by many presumptuous and negligent investors who fail to undertake any fundamental evaluation or regular assessments of their investments. Remember the tech bubble that transpired a little while back? There’s your classic extrapolation failure.
Now, you can appreciate how multi-faceted the seemingly simple idea of risk truly is. Learn how you can enhance your newly-gained knowledge and how you can use it to manage your investments. Most of all, use it to fine-tune your ability to measure your risk tolerance level in order to aid you in making better investment decisions.