Understanding Investment Risk: Types and Implications

1. What is it? • The notion of investment risk must take into account the possibility that the return may be positive (but greater or lesser than expected), zero, or negative. • There can be wide variations in the magnitude of either positive or negative returns. • When all possibilities (positive or negative returns and the variations in the magnitude of each type of return) are examined, investment risk can be more accurately defined as the variability in the expected return from an investment. • The greater the potential variation in the investment’s expected return, the greater is the actual risk of owning the investment.

2. What is it? • Investors must examined each investment separately because the various forces affecting return have a different impact on each type of investment. • The total investment risk for a particular asset depends on the combined effect of many forces. • Before investing in certain products, it is important to understand the various risks that are associated with them. • Investments may be exposed to a number of different types or sources of risk.

3. Actuarial Risk • Risk an insurance underwriter covers in exchange for premiums, such as the risk of premature death.

4. Agency Risk • Agency risk is the risk associated with delegating decisions to an agent who may not always act in the client’s best interest if the objectives of the client and the agent conflict. • This is a widespread area of research in economic and financial theory involving the design of agency incentive and compensation systems that tend to correlate the agent’s rewards with the achievement of the client’s objectives. • The problem arises in the control, regulatory, legal, and incentive arrangements for government agencies, professional management of firms, professional portfolio and money managers, financial advisers, and many other areas.

5. Asset Class Risk • Stocks, bonds, and cash are the three major asset classes. • If investors allocate a disproportionate amount to any of the three main categories, or totally ignore one or two of them, they are subject to asset class risk. • It is prudent to diversify across all major asset classes even when investors want to give primary emphasis to one class in particular.

6. Bid-Ask Spread Risk • Securities sold over-the-counter by investment banking houses that make a market in the shares are subject to the risk that the bid-ask price spread will change. • Dealers change one price, the ask price, when they sell these securities and another lower price, the bid price, when they buy. • The spread, or difference, is the profit the market maker gets for making the market in the security and helps to cover the market makers cost in maintaining an investor of the securities. • Depending upon supply and demand conditions in the security or the entrance or exit of market makers in a particular security, the spread may change over time.

7. Business (Company) Risk • Business risk is an economic or operating risk reflected in the variability of a firm’s earnings. • Changes in earnings or the variability of earnings may result in changes in the investing public’s perception of the company and sudden changes in the price of the stock. • In worst case scenarios, companies may fail, leaving their stocks or bonds worthless. • The best defense against this particular risk is to invest • In more than one company, and • In companies engaged in different lines of business

8. Business (Company) Risk • Business risk is composed largely of four risk subcategories: • Management risk: Financial difficulties can arise from management’s inability to handle change or failure to adapt to changing competitive conditions. • Product or obsolescence risk: Shifting demand or changes in consumer tastes and preferences can quickly leave companies with the capacity to produce the unwanted. • Also termed technological or innovative risk • New innovations or technologies can make a company’s products or processes no longer state-of-the-art. • Legislative/regulatory/tax risk: Changes in the law can affect a company’s fortunes

9. Business (Company) Risk • Business risk is composed largely of four risk subcategories: • Financial risk: This is the risk related to the mix of debt and equity used by a firm to raise capital. • The more debt is in a firm’s capital structure, the greater is its financial risk. • Debt financing, as opposed to equity financing, obligates a firm to make periodic interest payments and to repay the amount borrowed at some future date. • Before a firm can distribute dividends to its common stockholders, it must meet its fixed-payment obligations. • Failure to meet these obligations when they are due will result in insolvency or bankruptcy.

10. Call (Prepayment, Redemption) Risk • Many bonds and some preferred stocks are issued with what is known as a call feature. • The call feature gives the issuer the right to call the bond – to retire it after a certain date or on several dates before maturity. • Generally, bonds will be called only when it is profitable for the issuer to do so. • This occurs when interest rates have declined since the bonds were issued. • The high interest issue is then called and replaced with a new issue that is sold at a much lower interest rate. • Therefore, call risk inherently includes reinvestment risk as well.

11. Country Risk • Country risk refers to the risk that a country will not be able to honor its financial commitments. • When a country defaults, it can harm the performance of all other financial instruments in that country, as well as other countries with which it has relations. • Country risk applies to stocks, bonds, mutual funds, options, and futures that are issued within a particular country. • This type of risk is most often seen in emerging markets or countries that have a severe deficit.

12. Call (Prepayment, Redemption) Risk • This is the risk that a government, company, or individual will be unable to pay the contractual interest or principal on its debt obligations. • This type of risk is of particular concern to investors who hold bonds within their portfolio. • Government bonds, especially those issued by the federal government, have the least amount of default risk and the lowest interest rates among bond issuers. • Corporate bonds tend to have the highest amount of default risk, but also the higher interest rates.

13. Currency (Foreign Exchange) Risk • Foreign holdings may change in value as the value of currency changes. • Fluctuating exchange rates are of particular concern to single-country investors. • Currency fluctuations can be devastating for individuals who hold funds for short periods. • Currency risk is generally not too much of a problem for long-term investors in well diversified international funds.

14. Depth of Market Risk • Depth of market risk is related to bid-ask spread risk and is related to securities that are relatively thinly capitalized. • An investor trying to sell a relatively sizeable position in a thinly capitalized stock may find that there are not enough willing buyers at the current price to absorb his entire sale. • Consequently, the very act of selling may depress the price and reduce the investor’s gain or increase his loss.

15. Discount or Premium Risk • Closed-end investment companies listed on organized exchanges or sold over the country typically trade at values different from their net asset values (NAV). • The NAV is the value at which the securities underlying a share in the fund would trade if they were purchased directly in the market, rather than through the closed-end fund.

16. Documentation Risk • The risk of loss due to an inadequacy or other unforeseen aspect of the legal documentation behind the financial contract.

17. Event Risk • Mergers, acquisitions, and other major occurrences can significantly affect a specific investment asset. • Example: When one firm announces its intention to acquire another, the share prices of both companies are affected. • This risk applies to bonds to some extent as well.

18. Financial Risk • This is the risk related to the mix of debt and equity used by a firm to raise capital. • The more debt, the greater the risk from required periodic interest payments and potential default and bankruptcy. • The market’s perceived level of this risk affects not just the company’s cost of borrowing for bond issues and the value of its stock, but also the availability of lines of credit and financing for inventories and working capital, its credit terms with suppliers, and, ultimately, much of its cost of doing business.

19. Geographical or Location Risk • This risk is most typically associated with real estate. • However, it is a broader concept as well, relating to regional economic factors. • In some ways, it is a smaller-scale version of country risk.

20. Industry or Sector Risk • This risk relates to uncertainties caused by particular features of the industry sector in which a company operates. • These risks can vary dramatically. • Industry risks can be identified and differentiated on a scale from high to low, relative to the market average.

21. Inflation (Purchasing Power) Risk • The purchasing power of the dollar declines during periods of inflation. • Inflation has been moderate in recent years; however, during certain times it has been quite substantial. • Assets that are most susceptible to this risk include fixed income and cash assets. • The risk associated with inflation is not so much with the level of inflation. • The risk is with respect to unanticipated changes in inflationary expectations. • Investments tend to be priced in the market to yield returns that account for anticipated inflation and give investors the real returns that are commensurate with their risk levels.

22. Inflation (Purchasing Power) Risk • Income taxes are paid on nominal returns, not real returns. • As inflation rates increase, real effective income tax rates also increase. • Furthermore, inflation could be considered a form of tax, since investors can buy less in the future than what they can buy today. • Real inflation-adjusted return on investment, r (r) = (R-I) / (1+I) Where R is the nominal rate of return, and I is the inflation rate.

23. Interest Rate Risk • Interest rate risk is really two different risks: • Capital value risk • Reinvestment risk • Capital value risk refers to the behavior of bond prices in response to unanticipated changes in interest rates. • If investors expect market interest rates to rise, they might want to avoid purchasing long-term bonds unless they think the current price already reflects expectations. • The price of a bond in the secondary market is a function of its coupon yield, the time it has to maturity, and the movement of market interest rates since it was first issued.

24. Interest Rate Risk • Reinvestment risk is the other side of the interest rate risk coin. • If interest rates rise, investors in shorter-term notes and bonds can profitably reinvest at higher rates and avoid the capital value loss associated with the longer-term investments. • If interest rates fall, then the shorter-term note and bond owners will have to reinvest at lower rates when they could have locked in higher rates by originally buying longer-term bonds.

25. Inventory Risk • Inventory risk is the possibility that price changes, obsolescence, or other factors will shrink the value of a company’s inventory.

26. Liquidity Risk • Liquidity risk is related to bid-ask spread risk and depth of market risk. • The possibility of not being able to sell an asset at a relatively known value, when one wants to, adds an element of risk to an investment.

27. Longevity Risk • This is the risk that a person will live longer than the period his income can support.

28. Management Risk • Management risk is related to agency risk. • In the case of companies, the risk is related to the poor judgment or malfeasance of a company’s professional management. • In the case of professional investment managers, the majority of actively managed funds under-perform board market benchmarks.

29. Market Risk • Market risk relates to the day-to-day fluctuations in a stock’s price. • Applies mainly to stocks and options • Volatility is not so much a cause but an effect of certain market forces. • It is a measure of risk because it refers to the behavior, or temperament, of an investment rather than the reason for the behavior. • Because market movement is one reason why people can make money from stocks, volatility is important for returns. • The more unstable the investment, the more chance its value can move dramatically either way.

30. Market Risk • Broadly speaking, the term market risk is sometimes used to encompass all the political, economic, geographic, and other forces that can influence the financial markets and affect the return of most assets. • Economic risk refers to the uncertainty of broad economic variables, such as economic growth levels, inflation, interest rates, foreign exchange rates, import-export prices, etc.

31. Other Risks • Measurement Risk: The risk associated with the collection and accuracy of financial data and with the proper use and application of that data for estimating future company or security values. • Political Risk: Includes legislative/regulatory/tax risk, risk of war, etc. • Security Risk: A broad risk term encompassing all the risk factors associated with a particular stock, bond, options, or other financial security. • Size Risk: Risk associated with a firm’s size. Risk and return vary, systematically, by the size of companies.

32. Other Risks • Style Risk: Risk associated with different management styles of professional managers and advisers, as well as with the stocks being classified into value and growth. Each style has its own risk / return profile, so an investor with a concentrated portfolio may be investing in the wrong class at the wrong time. Systematic Risk: Widespread or economy-wide risk that influences a large number of assets. It is virtually impossible to protect oneself against this type of risk.

33. Other Risks • Tax (Rate) Risk: Investors have to be cautious in changes in tax laws that could make their holdings less valuable. • Timing Risk: Investors run the risk of investing when security prices hit their peak or of selling at a loss during a market setback. • Tracking Risk: Risk associated with managers of indexed funds to accurately, timely, and cost-effectively track and match the underlying index’s performance.

34. Other Risks • Underwriting Risk: The risk taken by an investment banker that a new issue of securities purchased outright will not be bought by the public and/or that the market price will drop during the offering period. • Unsystematic (Specific, Diversifiable) Risk: It is risk that does not have wide spread impact, such as the impact an economic recession has on virtually all investment assets. It is risk that affects a particular company or security, or a very small number of assets.

35. Investment Risk Management • Diversification • Because each asset class and each specific asset carries its own unique degree of risk, it may be best to diversify money across a range of investments. • An appropriate mix of aggressive, moderate, and conservative investments could help balance the overall risk of a portfolio.

36. Investment Risk Management • Asset Allocation • Before choosing individual investments, it may be a good idea to determine how much money should be allocated to each asset class. • By blending one’s portfolio, an investor can reduce short-term volatility, while maintaining the potential to achieve long-term financial goals. • Professional Management • Many investors have turned to professionally managed products. • Along with offering diversification, each portfolio is closely monitored by an expert manager who makes investment decisions based on careful analysis and thorough research.

37. Investment Risk Management • Modern portfolio and capital market theory posits that investors who are willing to bear greater investment risk can expect greater returns. • The theory does not say that all risks will be rewarded. • Investors are only rewarded for bearing systematic risks, those risks that cannot be diversified away. • Investors must balance risks by investing in a wide array of sectors or asset classes by applying the principles of modern portfolio and capital market theory.