“If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get.”
-Charlie Munger, Interview with BBC
Investment risk equals losing your capital or money on an investment. We have multiple ways to define risk; measuring that risk remains a full-time occupation.
Many new investors start nervously about losing money on their investment, while seasoned investors remain more worried about not beating a benchmark.
Both remain a matter of perspective and also a form of risk. Losing money is everyone’s fear and the most common form of fear of most investors. But the fear of not beating a benchmark remains a real fear for more experienced investors.
Learning more about investment risk, the components of risk, and what drives us to choose the risks we undertake is a fantastic way to evaluate our performance.
Understanding the different components of investment risk, how to measure it, and how to manage it are the goals of today’s post.
Because as Charlie so eloquently points out, if we can’t stomach any fluctuations in the market or tolerate any risk, investing in stocks might not be for us.
In today’s post, we will learn:
- What Is Investment Risk?
- What Are the Types of Investment Risk?
- How to Measure Investment Risk
- How to Manage Investment Risk
Okay, let’s dive in and learn more about investment risk.
What Is Investment Risk?
Investment risk, as defined by Investopedia:
“Risk is defined in financial terms as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes losing some or all of an original investment.”
We can see that risk encompasses both the loss of potential gains and the permanent loss of capital.
Buffett and Munger refer to investment risk as the potential loss of capital, i.e., bankruptcy or permanent loss of investment.
We can quantify risk by looking at historical behaviors and outcomes. I like to study history, and looking at the behavior and the outcomes helps me handle today’s events.
As Mark Twain said, “history doesn’t repeat, but it certainly rhymes.”
Studying events such as the Great Depression can help us understand the risks evident in hindsight. Looking at the reactions before the Depression helps highlight any investment risk we might face today.
As stock pickers or investors, it is a great idea to understand the basics of risk and how it is measured to learn to manage investment risk.
Avoiding unnecessary and costly losses should be the goal of every investor. Sins from omission, as well as the commission, is the goal. Learning from mistakes of our own making helps make us better investors and mistakes that others make.
Avoiding the risky investment that goes awry is as important as the great investment we make.
What Are the Types of Investment Risk?
In this section, we will discover the different types of investment risk. Each investment we make has exposure to some risk, such as market risk or loss of investment. Understanding those types of risks helps us potentially avoid them.
Let’s work through the list of investment risks.
Market risk equals the risk of any of our investments losing value from any situation in the market. We have three main types of market risks:
- Equity risk – investing in stocks brings on the risk of volatility. Stocks remain quite volatile, meaning the price of the stock or company fluctuates in the market. Price changes upward or downward are normal, but the sudden drop in share price remains the most equated to losing value.
- Interest Rate risk – debt securities or bonds feel interest rate risk keenly. Interest rates correlate to bonds; when interest rates rise, the prices of bonds fall. And when interest rates fall, then the prices of bonds rise.
- Currency risk – if you invest in foreign markets, the risk of fluctuations in those currencies’ value affects your investments’ value. But, not talked about much, if the business you invest in also has a large portion of its interest outside of your home country, you will have exposure to this risk. Aflac is a great example of this; it generates almost 75% of its business from Japan, even though based in the U.S.
Liquidity risk is the risk of being unable to sell your investments when you wish. If the other side of the trade is not there, selling an investment when the price falls are risky.
An investor might have to sell their investment for less than they wish. If you sell the investment for less than you purchased, then you risk losing money on the investment.
The concentration risk centers around focusing your investments on a small group of investments, a single investment, and the possibility of that investment failing.
If you put all of your eggs in one basket, says investment in one company, you lose all of your eggs if the company fails.
Credit risk focuses on the bond market; if the underlying company struggles financially, they might not pay its interest payments or declare bankruptcy. Then the bondholder loses their investment.
That is why paying attention to the company’s credit rating and issuing the bond is so important. In this case, using a credit rating agency such as Moody’s can help you track the risk of default.
The risk of losing out on greater returns when your investment matures and the reinvestment choices for the capital offer lower returns than the past investment.
For example, if you have a long-dated CD maturing and the Cd pays a rate of 10%, and when you look for options to reinvest, your rates are much less than the original investment.
In other words, the grass is not always greener on the other side.
Inflation remains the unhidden cost of investing, a force we don’t see daily, but it equals the loss of purchasing power of our money.
You can see inflation risk in the investments in savings accounts from brick-and-mortar banks. Most U.S. banks pay an interest rate of 0.01%, well below inflation, even at 1%.
All of this means if you put your money in a savings account for a long period, you risk the dollar being worth less than when you invested the dollar.
Horizon risk is anything shortening your investment horizon. One of the proven methods of wealth creation is investing for a long time, and if you buy a house, lose your job, or get married, those life changes can alter your time horizon.
If you lose your job until you find another job, the time has passed, and you lose out on the compounding effect. Same with purchasing a home, the outlay of money takes away from investments compounding.
Longevity risk is the risk of outliving our investments or having enough money to last our lifetime. With the creation of social security as a safety net, as long as it stays solvent, it allows for at least a minimum of money.
But setting your investments to allow you to earn income to the end of your life is one of the details that we need to incorporate into our plan.
The risk/reward tradeoff balances wanting the lowest risk while getting the highest return; it is the basis of the modern portfolio theory. The only way to get a higher return is to take higher risks.
Many feel that lower risk equals lower returns and vice versa.
As investors, we have to decide on the balance we want to walk, and as Warren Buffett and Charlie Munger remind us, find great companies at reasonable prices, and time will take care of the rest.
How to Measure Investment Risk
There are five principal measures of risk, each with a unique focus on risk.
The five measures are:
- Standard deviation
- Sharpe ratio
We, investors, can use the above measures to perform a risk assessment. When analyzing investments and assessing risk, it is always best to compare oranges to oranges.
In other words, please don’t compare the risk of a cloud computing company and a bank, they are not the same types of risk, and the comparison will not lead to a good result.
Alpha – Alpha is the term used to describe a market-beating investment or excess returns compared to a benchmark such as the S&P 500.
Beta – used to measure the overall volatility of the market, also known as systematic market risk.
R-squared – is a statistical measure that uses regressions to explain one variable’s movement compared to a dependent variable.
Standard deviation – another statistical measure that measures asset price volatility compared to their historical averages over a given period.
Sharpe Ratio – is a ratio that measures the average return earned over the risk-free rate compared to risk or volatility.
The use of the above measures of risk is a great way to find companies that meet your risk profile.
The links above direct you toward the Sharpe Ratio and Jensen’s Alpha, a measure of your portfolio’s alpha or return versus a benchmark, for deeper dives into those risk measures.
I want to discuss Beta more, as it is a major component of the DCF model, which we use to determine its intrinsic value.
Beta is used in the CAPM (capital asset pricing model) to describe the relationship between systematic risk and the returns expected by investors. It is associated primarily with the stock market.
CAPM models use beta as a component to price risky securities or stocks and generate the estimated return on investment.
CAPM considers both the risk of the investment and the cost of capital for that investment.
Beta about an individual stock only approximates the risk of a stock that might add to a portfolio. For beta to have meaning, it is best to relate it to the calculation used.
The basing of a beta value measure on 1.0 indicates the price of a company correlates to the market. It also means that the company has systematic risk; if the market rises, it rises, and vice versa.
A beta value of less than 1.0 means the company is less correlated to the market and may be less risky. For example, utilities have beta’s less than 1.0 because they move slower than the market.
A beta value greater than 1.0 indicates its price might equal greater volatility than the market.
For example, if the company’s beta equals 1.3, the company is 30% more volatile than the market. Tech stocks tend to have higher betas, as their prices remain more volatile than the market.
As it applies to a DCF, the higher the beta, the higher the cost of equity, which increases the discount rate we use in a DCF formula. Therefore, understanding the meaning of beta and its relationship to risk and volatility will help you understand its impact on intrinsic value.
How to Manage Investment Risk
Even though we have risks to investing, we have ways to mitigate the risks. We can manage the risk and controlled in various ways, depending on our strategy and plans.
The first strategy to use when trying to control investment risk is the idea of diversification. Diversification includes spreading our investments around different asset classes, such as:
- Real estate
- Savings accounts
By diversifying our portfolio among different asset classes, we dilute the impact a drawdown or downturn in the market will have on the whole portfolio.
For example, if we have an explosion in the stock market, bond real estate remains unlikely to feel impacts from the downturn. Likewise, the bond market feels the impact when interest rates rise, but stocks will not react as much.
The idea of diversification is if you equally weigh your assets across the asset classes, you help minimize each class’s correlation. All of this helps lower the portfolio’s risk because not all classes move in correlation to each other.
If we have a general market downturn, such as the Great Financial Crisis, diversification might help lessen the downturn’s impact because some assets might not fall as much.
The second strategy is creating less risk with the investments you buy.
For example, if you invest in lower-risk assets like bonds, savings accounts, and Treasuries, you lower your portfolio’s volatility. Corporate bonds, Treasuries, and savings accounts remain the investments with the lowest volatility and help lower your portfolio’s risk profile.
The returns these types of investments earn are lower than stocks, but the tradeoff is greater liquidity and lower volatility.
As you move up the pyramid, the volatility of the investments increases, where stocks remain more volatile than bonds, and options offer more volatility than stocks.
A way to lessen the risk of a stock portfolio is to choose less volatile stocks, such as buying an investment like a bank or utility. Those companies have lower risk profiles than cloud computing, which lowers the risk.
As you move up the pyramid, you find less risky assets in each class, helping manage the risk.
The third strategy includes buying companies with a margin of safety. Using the margin of safety allows you to find companies selling for less than their value, allowing us to lessen the risk of that investment.
The margin of safety allows for any mistakes in calculating the company’s intrinsic value or assessment. In case we are wrong, we have a built-in price that allows for less of a loss if we are wrong.
The margin of safety is the hallmark of value investors, created by Benjamin Graham and popularized by Warren Buffett.
The final idea of risk management is the idea of consistent investing or dollar-cost averaging. By investing consistently and using small amounts over time, we can average our investment and lower our costs.
A dollar-cost averaging strategy allows you to smooth out your investments over time. The DCA strategy is the idea behind regular contributions to your 401k at work.
The above ideas are the tip of the iceberg when considering managing risk in your investments. Maybe a post for the future?
The blunt reality is all investments carry some level of risk. Stocks, bonds, mutual funds, ETFs, and real estate can all lose value at some point.
Even conservative investments such as a CD issued by a bank comes with the risk of inflation. The longer we hold the CD, the more risk the investor takes; they will not find an investment better than the maturing CD.
Historically, stocks have earned a higher annual return with returns averaging 10%, corporate bonds have earned around 6% historically, Treasury bonds at 5.5%, and short-term Treasuries around 3.5%.
The tradeoff is that stocks carry more risk than bonds, and you get higher returns to compensate for the risk.
Based on historical numbers, holding a broad portfolio of stocks and bonds over a long period significantly reduces the risk of losing your investment or capital.
As an investor, we must understand investment risk and our risk appetite. Understanding that risk profile will allow us to create a portfolio that matches that risk profile and will meet our investment goals.
There are as many ways to set up a portfolio as there are investments. So understanding risk and how it affects us will allow us to choose what works best for our goals.
And with that, we will wrap up our discussion of investment risk.
As always, thank you for taking the time to read this post, and I hope you find something of value in your investing journey.
If I can further assist, please don’t hesitate to reach out.
Until next time, take care and be safe out there,