With any kind of investment or business, there is always risk involved, somehow.
Whether it be the risk of an accelerated inflation rate or a volatile stock, risk is a huge factor to examine and understand when getting into the market (or even as a business or corporation).
And in recent years, with trade wars and questionable interest rates, it seems as though risk may be more of a prevalent topic when it comes to placing your money in an investment vehicle - or even starting a business.
Given that the term "risk" is so broad, what actually is risk, and what are different types of risk?
What Is Risk?
Although it is often used in different contexts, risk is the possibility that an outcome will not be as expected, specifically in reference to returns on investment in finance. However, there are several different kinds or risk, including investment risk, market risk, inflation risk, business risk, liquidity risk and more. Generally, individuals, companies or countries incur risk that they may lose some or all of an investment.
In an investor context, risk is the amount of uncertainty an investor is willing to accept in regard to the future returns they expect from their investment. Risk tolerance, then, is the level of risk an investor is willing to have with an investment - and is usually determined by things like their age and amount of disposable income.
Risk is generally referred to in terms of business or investment, but it is also applicable in macroeconomic situations. For example, some kinds of risk examine how inflation, market dynamics or developments and consumer preferences affect investments, countries or companies.
Additionally, there are many ways to measure risk including standard deviation and variation.
But, what is risk in investing?
Risk in Investing
In investing, risk is measured by the standard deviation equation (commonly used in statistics) - and, logically, it makes sense. The equation measures how volatile the stock is (its price swings) compared to its average price. The higher the standard deviation, the higher the risk for a stock or security, and the higher the expected returns should be to compensate for taking on that risk.
Low-risk stocks tend to have fewer swings in price and therefore more modest returns on investment. However, high-risk stocks typically swing dramatically (or are expected to) in price and can often see huge returns. However, because they are more risky, the investor is taking more of a chance that the return on their investment won't be what they expect (and may in fact cause them to lose their entire investment).
A major concept that comes into play when evaluating risk in your portfolio is your time horizon. Essentially, a time horizon is how long you are able to keep your money in the market or the individual stock. If you have a long time horizon, you can generally invest in higher risk stocks because you have more time to ride out any dips in the market. However, if you have a short time horizon (meaning you can only keep your money in the market or the stock for a short period of time), you may need to pick lower risk investments that have less of a chance of dipping dramatically.
Different Types of Risk
While the term "risk" is fairly general, even verging on vague, there are several different types of risk that help put it in a more concrete context. So, what are some of the kinds of risk, and how do they affect investors or businesses?
In a nutshell, business risk is the exposure a company has to various factors like competition, consumer preferences and other metrics that might lower profits or endanger the company's success.
When entering a market, every company is exposed to business risk in that there are various factors that may negatively impact profits and might even lead to the business' demise - including things like government regulations or the overall economy.
Within the general blanket of business risk are various other kinds of risk that companies examine, including strategic risk, operational risk, reputational risk and more. In a larger sense, anything that might hinder a company's growth or lead it to fail to meet targets or margin goals is considered a business risk, and can present in a variety of ways.
Particularly in investment, volatility risk refers to the risk that a portfolio may experience changes in value due to volatility (price swings) based on the changes in value of its underlying assets - particularly a stock or group of stocks experiencing volatility or price fluctuations.
Stocks are often given ratings, called "beta," which help investors detect which stocks may be more of a risk for their portfolio. The beta value measures a stock's fluctuations compared to the overall market or a benchmark index like the S&P 500.
Inflation risk, sometimes called purchasing power risk, is the risk that the cash from an investment won't be worth as much in the future due to inflation changing its purchasing power. Inflation risk primarily examines how inflation (specifically when higher than expected) may jeopardize or reduce returns due to the eroding the value of the investment.
In general, inflation risk is more of a concern for investors who have debt investments like bonds or other cash-heavy investments.
Although inflation risk may not be the primary concern for investors, it definitely is and should be on their minds when dealing with cash flows over a long period of time in investment vehicles or when calculating expected returns. The longer cash flows are exposed, the more time inflation has to impact the actual returns of an investment and eat away at profits - specifically if inflation is at an accelerated rate.
Market risk is a broad term that encompasses the risk that investments or equities will decline in value due to larger economic or market changes or events.
Under the umbrella of "market risk" are several kinds of more specific market risks, including equity risk, interest rate risk and currency risk.
Equity risk is experienced in every investment situation in that it is the risk an equity's share price will drop, causing a loss. In a similar vein, interest rate risk is the risk that the interest rate of bonds will increase, lowering the value of the bond itself. And currency risk (sometimes called exchange-rate risk) applies to foreign investments and the risk incurred with exchange rates for currencies - or, if the value of a certain currency like the pound goes up or down in comparison to the U.S. dollar.
Liquidity risk is involved when assets or securities cannot be liquidated (that is, turned into cash) fast enough to ride out an especially volatile market. This kind of risk affects businesses, corporations or individuals in their ability to pay off debts without suffering losses. As a general rule, small companies or issuers tend to have a higher liquidity risk due to the fact that they may not be able to quickly cover debt obligations.
Essentially, if an individual or company is unable to pay off their short-term debts, they are at liquidity risk.
But how do you manage risk? And what is risk management?
Risk management is the process and strategy that investors and companies alike employ to minimize risks in a variety of contexts. Risk management can range from investing in low-risk securities to portfolio diversification to credit score approval for loans and much more.
For investors, risk management can be comprised of balancing or diversifying portfolios with a range of high- and low-risk investments, including equities and bonds. The general rule seems to go that the wider range of investments that are deemed more or less risky (based on how volatile the security is or how drastic its price swings are), the more risk-managed the portfolio and less risky the investment.
There are various strategies companies and individuals alike employ to avoid incurring too much risk.
Avoidance of risk is a commonly used strategy by businesses to, well, avoid risk. While the strategy is rather vague, avoidance of risk includes things like opting not to purchase a new factory if the risks to the business outweigh the benefits (which, presumably, the company has determined through cost benefit analysis).
Additionally, strategies like risk mitigation seek to minimize the effects of risk instead of avoiding them entirely. For example, a beverage company like Coca Cola (KO) could avoid having to recall a product for health reasons by conducting an inspection of their product before it goes into the retail space and into consumers' hands.
Transfer of risk is also a strategy employed to minimize risk by transferring it to another party - a common example of which is insurance. A company or individual could transfer the risk of damage or loss to a building (or similar asset) by paying a premium for insurance and protecting themselves from having to pay in full if the property is destroyed.
And while there are many other examples of risk management - both for individual investors and companies - what are some actual examples of risk?
Examples of Risk
One major example of both financial risk and liquidity risk is the Toys "R" Us bankruptcy filing, announced in September of 2017. The company experienced financial risk through a leveraged buyout in 2005 to the tune of some $6.6 billion by mega firms like Bain Capital (BCSF) , Vornado Realty Trust (VNO) and KKR & Co. (KKR) . However, unable to compete with companies like Target (TGT) and Walmart (WMT) , Toys "R" Us attempted to liquidate over 700 of its locations in 2018 - but experienced liquidity risk in doing so as it struggled to sell them. Many analysts have claimed the disaster was a strong example of financial and liquidity risk, especially in regard to debt buyouts, for investors and creditors.
Additionally, another example of risk is the currency risk involved when an investor or country holds assets or debts in foreign markets.
For example, the 1994 Latin American crisis (also dubbed the "Tequila Crisis") illustrated the risk of holding assets in different currencies when several of the countries were unable to pay back foreign debt due to it exceeding their earning capacity because of a sudden loss of value in the Mexican peso.
The crisis negatively impacted emerging markets as well, and the depreciation of the peso forced the U.S. (under President Bill Clinton) to organize a $50 billion bailout, facilitated by the International Monetary Fund. As an example of the risk inherent to holding debts or assets in foreign currencies, the crisis is but one example of a country feeling the shocks of a sudden depreciation of currency. But currency risk can also apply to individual investors who hold securities or assets in foreign stock markets.
Still, there are dozens of other examples of risk - ranging from stock volatility to inflation risk and more. And so long as risk is acknowledged, it can become easier to find a strategy to avoid or mitigate that risk.
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