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What Are the Risks of Investing?

NEW YORK (TheStreet) -- 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.

Credit risk is subjectively quantified in those ratings, but an individual company's rating may be subject to a credit upgrade or downgrade. We call this situation being under "credit watch." As an investor, you must incorporate this scenario into your credit risk management. Some investors are prohibited from holding non-investment-grade debt, and slipping from investment grade to non-investment grade will have the potential to result in portfolio liquidation and thus add to one's personal credit risk profile.

Counterparty risk:

When engaging in a transaction with another party, not only do you have to concern yourself with the ability of that counterparty to pay, you also have to worry about that party's willingness, desire or ability to abide by the covenants of the transaction. While credit risk and counterparty risk may seem similar, they pose different risks to investors.

Credit risk focuses on debt repayment, while counterparty risk focuses on performance of contractual obligations. For example, let's say that you invest in building a new addition to your house and it has a leak in the roof, but the contractor refuses to fix it. In a situation like this, you're exposed to counterparty risk with the contractor for a failure to perform. You can sue that contractor and obtain a judgment. Once you have a judgment, you then add credit risk to the equation, because now you've become an unsecured creditor of the contractor.

Sovereign risk:

While many nations issue their own government debt, you need to understand that such debt is most likely unsecured and issued by sovereign nations against which investors have virtually no power to enforce repayment. There are many instances of sovereign nations issuing worthless debt, such as the Weimar Republic before Hitler's rise to power and, more recently, Argentina's debt default in 2001-02.

Estimation risk:

In a previous lesson, I covered earnings releases and earnings calls. Analysts derive EPS and revenue estimates, which they aggregate into consensus estimates. These estimates are only educated guesses as to what to expect from each company when it reports.

Companies will also provide their own guidance, which is management's estimate of how the company will perform for certain reporting metrics. The risk here is that such estimates are either too high or too low.

Recently, Men's Wearhouse warned investors a month before its earnings release that EPS for the first quarter of 2007 would be at the low end of its guidance. MW stock sold off in reaction to that information. When Men's Wearhouse reported its actual first-quarter results, EPS was at the high end of its previous guidance. This caught many people off-guard and sent the stock up nearly 10% on that day.

Extrapolation risk:

This is the risk associated with using historical trends to predict future prices. As an example, suppose you observe a stock that has risen 20% per year for each of the last five years. By extrapolation, you assume that the stock will rise another 20% the following year and you buy it with that expectation in mind. However, there is no guarantee that the stock will rise 20% per year again just because of its history. In fact, it could decline the next year.

This error is made by many naïve and lazy investors who do not conduct any fundamental analysis or do not perform periodic reviews of their investments. Do you remember the tech bubble several years ago? That was a textbook extrapolation error.

As you can see, there are several forms of risks involved in the investment process. While this overview was not exhaustive, I did explain many of the most prevalent risks that you will encounter.

In a future lesson, I will discuss how to manage risk. Until then, here is your homework:

1. Look closely at your investments and identify the forms of risk that you are currently exposed to.

2. Analyze how your investments have reacted in times of major financial crisis or stress (systemic risk).

3. Before you make your next investment, ascertain your risk appetite (risk tolerance). Remember that without risk there is no real reward. However, it is important to fully understand how you feel about the trade-off between risk and reward (risk/reward relationship).

At the time of publication, Rothbort was long MW and SPY, although positions can change at any time.

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