Different risks of investment
The average individual investor is saving for retirement, a house, travel money or some other goal. They want some certainty that the money they put back now will be there when they need it. Because of this, it is important to analyze not only the opportunity an investment represents, but also the risk. Your ideal investment or investment portfolio will give you the greatest opportunity for the risk you can bear. In this sense, it is important to understand the risk inherent in an investment before looking for the opportunity. Unfortunately, the average investor does not understand risk even at a basic level. Most individual investors do not look at risk in any objective way. They base their decisions on perceptions and fears. They believe things like “Google is popular, the stock won’t go down” and “Lehman Brothers has been around as long as I can remember, it seems like they’re pretty stable.” At best, they will look at the beta of a stock. Unfortunately, beta is a measure of volatility and is a poor substitute for analyzing risk. More importantly, beta is always a historical figure and in no way represents what might happen tomorrow. Although investors often don’t analyze it, most realize that there are risks involved in investing. Let’s look at the different types of risk that investors face:
Market risk
The risk that most people are familiar with is market risk. Market risk is the risk that the market changes its perception of value for a particular investment. This risk is one of the most important risks when it comes to stocks, options and commodities. This is clearly shown by the daily changes in the share prices of all listed stocks. This risk can be analyzed by looking at the factors that make up the perceived value of the investment. You would then determine how accurate these assumptions are and how they might change in the future. Some of these factors include earnings, dividends, growth and perceived opportunities.
Default Risk
Another important risk that many people are aware of is Default Risk. This comes into play more with debt investments than with equity. Bonds, for example, all carry the risk that the issuer will not be able to make a payment when it is due. The primary factor in default risk is the cash flow, which can be different from income or revenue. If you own a bond that an issuer doesn’t have the money to pay, you would lose your accrued interest and principal. Default risk also has an indirect but important effect on equity investments because defaulting on debt can put a company into bankruptcy. In bankruptcy, debt holders get paid before shareholders. As a result, the stock will generally be worth less after a default and in extreme cases may lose its entire value. Diversification is very important to reduce the impact of default risk.
Interest rate risk
Interest rate risk is another risk that mainly affects bonds. The price of a bond can be easily estimated by determining the required rate of return (yield) and adjusting the price to bring the yield in line with what is required. In practice, this means that barring other factors, when interest rates fall, bond prices go up. When interest rates rise, prices go down. This is particularly important when we are at historically low interest rate levels. Low-risk bonds that were bought years ago at higher yields are now being sold at significant premiums, giving sellers substantial profits. Today’s buyers will have the opposite effect of buying when rates are low. When prices rise, the prices they can sell at will fall. This is very important for institutional buyers but is often overlooked by individuals trying to buy into something ‘safe’.
Opportunity risk
Opportunity risk is the risk that by buying an investment, you reduce the amount of money you have to invest elsewhere. This means that when you consider investing in Google (GOOG), for example, you are giving up the opportunity to invest the same money in Apple (AAPL). One is likely to gain more or lose less than the other, so you give up the possibility of that gain by buying one over the other. You can reduce this risk with careful research or diversification.
Liquidity risk
Liquidity risk is somewhat related to opportunity risk, but in a slightly more tangible way. This is simply the risk that you will not have money available when you need it. It could be that a CD has a significant penalty to be broken or it could be that a bond is not heavily traded and cannot be sold at a reasonable price on the open market. Your best return would be to wait until maturity, but the risk is that you will need it sooner.
Inflation risk
Inflation risk is one of the risks most overlooked by so-called conservative investors. This is the risk that the return on your investment will be lower than the rate of inflation. This results in having less purchasing power at the end of an investment period than at the beginning. Because this is not clearly visible in the dollars and cents of an investment, people easily overlook its importance. If you invest money for retirement today, you hope to spend as much in the future. The reality is that if you invest in a security that does not exhibit the other risks discussed but yields only 1% in a world with 3% inflation, you will effectively have less than you invested to spend in retirement. Discounting this risk is dangerous because you will end up with less market and default risk at the expense of inflation risk.
Systematic risk
Systematic risk, political risk, event risk and country risk are all similar in that they refer to risks outside the control of the investor or company. They represent the risk of something happening in the external environment that changes the value of an investment. A major hurricane or flood is an event risk that is closely related to real estate or insurance investments. When Katrina struck Louisiana, a number of insurance companies took bigger losses than investors expected them to take, reducing the value of investments in those companies. Health-related investments are currently facing political risks in the form of health reforms. It is currently unclear how any reforms will affect the profitability of hospitals or insurance companies. There is a risk that the changes will negatively affect investments in health companies.
Summary
These are the main risks associated with investments and can be found in most investments. Favorable trade-offs between these risks are important when choosing the right portfolio for your needs. For example, it is important to understand that although government bonds have low default and market risk components, they have higher inflation, opportunity and interest rate risks. It is dangerous to invest without considering these risks, or to ignore risks altogether. An investor who is well informed about all investment risks will be able to make better decisions with their money.
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