When it comes to investing, there are risks involved and it’s important for you to understand the various types of risks and what they entail. Understanding risk will allow you make better informed choices. The reason why we want to explore the different types of risk is because we want to avoid the ultimate risk – losing all of your capital. You must weight the potential reward against risk to decide if it’s worth putting your money on the line.
Understanding Risk & Reward
Understanding the relationship between risk and reward is a crucial piece in building your investment philosophy.
Investments such as stocks, bonds and mutual funds have their own risk profile and risk characteristics and understanding the differences can help you diversify and protect your investment portfolio. The higher the risk, the higher the return.
Equities
The majority of people have stocks in their investment portfolio and who can blame them. Since 1926, stocks have returned an average rate of 10% annually since 1926. This is a higher return that you would normally receive from other investment instruments such as bonds, which are less risky. Stocks are on the far-right end of the risk/reward spectrum. The more stocks that you’re holding in your portfolio, the more volatile your portfolio will be. However, you will experience a higher return long term if you’re buying established, blue chip companies that have a fairly stable stock price, pay out dividends and are considered relatively safe.
Fixed Income
Bonds, also known as fixed income are a popular way to offset some of the volatility in your portfolio that stocks bring. The rule of thumb is that when it comes to investing, you should keep the same percentage of bonds as your age. If you’re a 20 year old individual, you should keep 20% of your portfolio in bonds or fixed income. When you’re purchasing a bond, you’re lending money to a corporation, government or a municipal entity. Bonds are more safe than stocks and are given a rating from agencies such as Moody’s, Standard & Poors, etc. Ratings act like a credit score and bonds with AAA rating are usually considered safe.
When you buy a bond, you’re receiving a guarantee from the particular issuer that you’ll get your money back plus interest. Be careful that you do not buy junk bonds which are sold by corporations. Junk bonds also known as high yield bonds are issued by corporations but they come with higher risk than normal.
Mutual Funds
Many investors choose to invest in mutual funds because they’re managed by professional portfolio managers and their teams. This gives the investor a piece of mind when it comes to investing as they don’t have to worry about watching the market or monitoring their portfolios. A mutual fund is essentially a basket of stocks and when you buy a mutual fund, you’re buying a share of that basket. There are a wide variety of mutual funds to choose from and they have different risk profiles. Advantages of mutual fund are
- Convenience
- Affordability
- Access to your money
- Professional management
- Diversification
- Access to markets
If you’re not comfortable in investing in stocks or bonds yourself, it’s recommended that you invest in mutual funds as you might feel slightly comfortable with continuous oversight that mutual funds bring.
Every mutual fund provides a document called Fund Facts for investors. This includes the fund’s risk rating, based on the past volatility of the fund’s returns.
Various Types of Risks
- Capital Risk
- The most common type of risk is the danger that your investment will lose money. Markets will be volatile but if you can stomach the ups and downs of the markets, then you will be a successful investor long term. The lower you are on the risk and reward spectrum, the less likely you will lose your investment.
- Interest Rate Risk
- When interest rates rise the price of bonds decline. Interest rates also affect economic activity and borrowing costs.
- Default Risk
- Investing could expose you to default risk especially if the company is rated poorly by a credit agency.
- Inflation Risk
- Higher prices lower the purchasing power of your investments. If your investment returns don’t exceed inflation you are losing purchasing power.
- Economic Risk
- Economic recessions and depressions can have profound effects on asset valuations.
- Reinvestment Risk
- Let’s assume that many years ago you bought a Treasury Bond paying 8% that is maturing. Now the interest rate is less than 3%. If you reinvest it will have to be at a much lower rate.
- Liquidity Risk
- If you need to sell an investment you may not be able to find a buyer in a timely manner. Most publicly traded equity and bonds are fairly liquid. But many alternative investments such as real estate, art work, coins, stamps, etc. may experience periods when they are illiquid.
- Regulatory / Political Risk
- Governments have a large effect on social stability and the economic environment for investment. Look for political stability and business friendly policies.
- Purchasing Power Risk
- Inflation risk is the risk associated with a cost of living increase or reduced purchasing power. As the prices of goods and services rise, you have less money to spend at the end of the day.
- Market Risk
- It’s based on macroeconomic factors and it is risk that is present in all investments. This is referred to as systematic risk or non diversifiable risk. It’s usually measured by beta which we discuss below.
- Exchange Rate Risk
- You might experience uncertainty in acquiring securities denominated in a currency different from that of the investor. Changes in the exchange rate will affect your return when converting the currency back to your “home” currency.
Systematic vs. Non-Systematic Risk
- Systematic Risk
- Refers to market risk that affects all investors. It includes macroeconomic conditions, inflation, interest rate changes and economic direction. Systematic Risk is not diversifiable.
- Non-Systematic Risk
- Refers to risk that is unique to a business or industry. Adding low correlation funds into your portfolio will allow you to fully diversify your portfolio. Rational investors can eliminate non-systematic risk by diversifying their portfolio. Information on diversification can be found below.
Measurement of Risk
- Standard Deviation
- Standard deviation is the statistical measure of risk or uncertainty that measures the various possible returns. The larger the standard deviation, the great dispersion of expected returns and the greater the risk or uncertainty. Standard deviation is also often referred to as total risk, which includes both market risk and specific business risk.
- Beta (Market Risk)
- Beta measures the systematic risk of an asset in relation to the over all movement of the market. By definition, a beta is usually equal to 1. If the beta is lower than 1, this means that the particular stock is a defensive stock and less volatile than its peers. If the beta is greater than 1, this is a risky stock. Remember that systematic risk cannot be diversified away by adding more uncorrelated securities to the portfolio.
Influence of Time On Investment Risk
- Effects of Time on Investing
- The longer the investment time horizon, the more risk can be incorporated into the financial plan. Due to the volatile nature of stock prices, there is greater risk incurred in owning stocks if one has a short time horizon compared to someone who has a long time horizon.
- The opposite is true for investing in bonds. There is more risk associated with holding a bond long term because of the uncertainty of future inflation and interest rate levels.
Diversification
One of the most important things an investor could do is embrace diversification. Diversification can minimize risk without adversely affecting return. Investors can reduce their risk in the portfolios by including securities that have low correlation with one another. Doing so eliminates all unique business risks associated with each individual security. Market risk cannot be eliminated.There are various strategies that one can embrace in order to diversify their portfolios. These strategies can be used in combination.
- Asset Class – having stocks and fixed income in your portfolio will diversify your portfolio
- Company Size – large cap companies are more stable than small cap companies.
- Industry – adding companies in various industry will allow your portfolio to withstand business cycles
- Geographic – investing in different countries can reduce the risk of your portfolio
- Management Style – depending on the portfolio manager’s mandate, diversification can be achieved. (Value vs. Growth)
- Maturity – Bond laddering or GIC ladder can add diversification to a portfolio. Buying fixed income instruments at different intervals
- Credit – Including companies with strong credit rating and low credit rating such as high yield bond.
It’s important to find your comfort level with risk and develop an investment strategy around that level. A portfolio that carries a lot of risk may have the ability to generate higher returns but it may also cause you to lose your investments. There is no right or wrong amount of risk as it’s a very personal decision. By understanding risk, it will allow you to only take as much risk a you’re comfortable with and always remember that risk is a natural part of investing. As well, keep in mind other types of risks discussed when you’re choosing what to invest in.
