“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 is the risk of losing your capital or money on an investment. There are multiple ways to define risk, and measuring that risk is a full-time occupation. Many new investors are nervous about losing money on their investment, while seasoned investors are more worried about not beating a benchmark.
Both are 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 is a form of investment risk as the loss of gain is just as real as losing money.
Learning more about investment risk, the components of that 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 this 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
- Investor Takeaway
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 the possibility of 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 both 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 plus the outcomes helps me get a handle on events of today.
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 in general, 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 a better investor 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 is the risk of any of our investments losing value from any situation that presents itself in the market. There are three main types of market risks:
- Equity risk – investing in stocks brings on the risk of volatility. Stocks are 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 is the most equated to losing value.
- Interest Rate risk – interest rate risk is felt most keenly in debt securities or bonds. Interest rates are strongly correlated to bonds; when interest rates rise, the prices of bonds fall. And when interest rates fall, then the prices of bonds rises.
- Currency risk – if you invest in foreign markets, then 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, then you are exposed to this risk. Aflac is a great example of this; it generates almost 75% of its business from Japan, even though it based in the U.S.
Liquidity risk is the risk of not being able to sell your investments when you wish. If the other side of the trade is not there, then selling an investment when the price falls is at risk.
Meaning that an investor might have to sell its investment for less of a price than they wish. If you sell it 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, say an investment in one company, then you lose all of your eggs if that company fails.
Credit risk focuses on the bond market; if the underlying company struggles financially, it might not pay its interest payments or declare bankruptcy. In that case, then the bondholder loses their investment.
That is one reason why paying attention to the company’s credit rating that is 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 the investment you have matures and the reinvestment choices for that capital are less than the past investment.
For example: you have a long-dated CD that matures and was paying 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 is the unhidden cost of investing, it is a force we don’t see daily, but it is 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%, which is well below inflation, even at 1%.
All of this means that if you put your money in savings account for a long period, you risk that dollar being worth less in the future than when you invested that dollar.
Horizon risk is anything that shortens 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 for a time until you find another job, that time has passed, and you lose out on the compounding effect. Same with the purchase of a home, that outlay of money takes away from investments that can compound.
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, and each measure has a unique focus on risk.
The five measures are:
- Standard deviation
- Sharpe ratio
As investors, we can use the above measures, or in combination, to perform a risk assessment. When we are 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 towards the Sharpe Ratio and Jensen’s Alpha, a measure of your portfolio’s alpha or return versus a benchmark, for deeper dives into those measures of risk.
I want to discuss Beta a little more as it is a major component of the DCF model, which is used 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 of an 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 that the price of a company is strongly correlated to the market. It also means that the company has systematic risk; if the market goes up, it rises, and vice versa.
A beta value of less than 1.0 means the company is less correlated to the market and it may be less risky. For example, utilities have beta’s less than 1.0 because they move slower than the market.
A beta value of greater than 1.0 indicates that its price might be more volatile than the market. For example, if the company’s beta is 1.3, the company is 30% more volatile than the market. Tech stocks tend to have higher betas, as their prices are more volatile compared to 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 the intrinsic value.
How to Manage Investment Risk
Even though there are risks to investing, there are ways to mitigate that risk. The risk can be managed and controlled in various ways, depending on the strategy and plans we utilize.
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 there is an explosion in the stock market, bonds and real estate are less likely to be impacted by that downturn. Likewise, when interest rates rise, the bond market is impacted, but stocks will not react as much.
The idea of diversification is if you equally weight your assets across the asset classes, you help minimize each class’s correlation. All of which helps lower the portfolio’s risk, because not all classes move in correlation to each other.
If there is a general market downturn such as the Great Financial Crisis, then the diversification might help lessen the downturn’s impact because some assets might not be down as much.
The second strategy is the idea of creating less risk by the investments you choose to 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 are the investments with the lowest volatility out there 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 are more volatile than bonds, and options are more volatile 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 types of companies have lower risk profiles than a cloud computing company, 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 the idea of buying companies with a margin of safety. Using the margin of safety allows you to find companies that are selling for less than their value, allowing us to lessen the risk of that investment.
The margin of safety allows for any mistakes made in calculating the company’s intrinsic value or assessment. In case we are wrong, we have built-in a price that allows for less of a loss in the event 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, using small amounts over time, we can average our investment and lower our investment cost.
Using 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 ways to manage 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 the CD is held, the more risk the investor takes; they will not find an investment better than the maturing CD.
Historically, stocks have earned a higher annual returns with returns averaging 10%, corporate bonds have earned around 6% historically, and Treasury bonds at 5.5%, and short-term Treasuries around 3.5%.
The tradeoff is that stocks carry more risk than bonds, and to compensate for the risk, you get higher returns.
Based on historical numbers, if you hold a broad portfolio of stocks and bonds over a long period, you significantly reduce the amount of risk of losing your investment or capital.
As an investor, we need to understand investment risk and our risk appetite. Understanding that risk profile will allow us to create a portfolio that matches that risk profile 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 be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,