The Finance Professor: Understanding Risk

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 (MW Quote) 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.