Risk is another one of those investment terms that tend to get thrown around very loosely, like volatility. Of course investments are risky. You didn't get into this assuming every move you made would work out, did you?
Regardless, risk is an important term in the world of investing. It's also an incredibly broad term.
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. And just as with other facets of your life, there are several specific types of risk that you will need to factor in when dealing with your investments.
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). When you're able to make this separation and focus on the good risk while factoring out bad risk, you can ensure that the level of risk that you assume falls within your comfort zone.
As an individual investor, there are 8 basic risks you should always be aware of, both before you make your investment decision and afterward when you're holding onto it. Those risks are:
- Systematic Risk/Market risk
- Systemic risk
- Interest rate risk
- Credit risk
- Counterparty risk
- Sovereign risk
- Estimation risk
- Extrapolation risk
Let's break down what each of these means.
Systematic Risk/Market Risk
Systematic risk, also referred to as market 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.
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%.
Market risk can impact the entirety of the financial market - think of the recession of the late 2000s, where a number of volatile securities lost value. This risk is not something that can be avoided via portfolio diversification. However, some investors may try hedging strategies like purchasing put options.
This risk is associated with the potential for a complete breakdown of an economy, market or segment thereof due to a narrower problem within the system. While the recession of the 2000s was systematic risk, an example of systemic risk would be the 2008 collapse of Lehman Brothers. The failure of such a massive company sent shock waves throughout the financial world.
A systemic risk is a formidable danger posed to an investor. One particularly well-connected company's collapse could quickly cause others to fall like dominoes.
Interest Rate Risk
Interest rate risk is the fear that exposure to the term structure or nature of interest rates will create financial danger to an investor. If the interest rates rise, an older bond could become harder to sell and be worth less in value.
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 mortgagors). While interest rate risk has a direct impact on fixed-income investors, there is only a secondary effect on stock investors.
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 (S&P) 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.
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.
That's an active refusal to perform. Many other counterparty risks in investing, though, involve more of an inability to live up to the contract. Other forms of risk, like market risk and interest rate risk, could come into play as causes for a counterparty like a bank to default on a contract.
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. Changes that countries make to their exchange rates can drastically alter the value of a foreign investment, and economic crises abroad can affect a country's ability to repay its debts.
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.
Analysts derive earnings per share (EPS) and revenue estimates prior to earnings releases, 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 despite all the work put in by analysts, quite often these estimates are entirely wrong, and wind up either too high or too low.
Need an example? Recently, Apple was estimated to report an EPS of $2.69 for the second fiscal quarter of 2018 amidst questions of iPhone sales. During the earnings call, though, Apple announced an EPS of $2.73 and topped revenue expectations as well. After the announcement that day, Apple shares were up 3%.
If estimation risk involves using recent information to create estimates, 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. Remember the dotcom bubble? That was a textbook extrapolation error.
It's important to be aware of all these risks and more, and determine your risk tolerance. It can seem like a lot of pitfalls, but learning how to navigate these risks can help get you closer to a better reward.