Chances are, the topic of investment risk was not a popular cocktail party discussion during the 1995 to early 2000 bull market. Investors basked in the glow of the returns of their Internet and Telecom funds and talked very little of the trivialities of standard deviation and volatility. However, as these funds, held so dear just a few short years ago, are shutting their doors, the topic of risk in the investment arena has once again been brought to the forefront. It is a topic not understood by many investors, and one that is absolutely essential to evaluating every investment opportunity that may arise.
Typically, risk is defined as the degree of uncertainty associated with the return of an asset. Yet risk comes in many shapes and sizes, and the financial community has found a dizzying number of methods to quantify and develop techniques to attempt to keep it at bay. What follows is a short discussion of the varying types of risk as well as ways to measure risk on the whole.
Unsystematic risk is also known as diversifiable risk because it can be mitigated through diversification. Unsystematic risk refers to the business risk inherent in all companies. This type of risk can be boiled down into factors including but not exclusive to credit risk (the ability or inability to obtain adequate financing), business cycle risk (relating to the typical ebb and flow of industry forces) and threats posed to cash flow generation.
Unlike its cousin, systematic risk cannot be diversified away, and is caused by much broader forces. It is typically broken into four subcategories. They are as follows:
· Market Risk Broad political, economic and social forces can affect the stock and bond markets.
· Interest Rate Risk This occurs typically when investment returns are affected negatively by increases in interest rates
· Currency Risk Fluctuations in exchange rates when investing internationally may cause poor performance.
· Inflation Risk The risk of investing and not providing a higher return than annual consumer price increases (CPI)
It is important to note that equities are not the only asset class that is exposed to a certain degree of risk. Your grandmothers portfolio of short-term Treasury Bills and 3-month CDs is anything but risk-free if it cannot outlast inflation. Correspondingly, even the astute investor, attempting to eschew risk with his newly-minted bond portfolio may be in for a rough journey if interest rates rise to their historical levels of near six (6%) percent.
As with most abstract topics, the financial community has spent long hours attempting to quantify risk, which takes an otherwise abstract topic and boil it down to a single number. Generally speaking, investment analysts use only two methods to scrutinize risk, beta and standard deviation. Beta refers to a securitys overall sensitivity to market conditions as represented by the S&P 500 for example. For instance, if a prized stock in ones portfolio sports a beta of 1.5 and the market returned 10% for the past year, in theory, the stock would have netted a 15% gain. Likewise, if the market had plummeted by that same amount, the stock would have lost 15% for the year. Beta is generally considered the preferred measure of risk in the equity markets when measuring domestic equities, especially by the academic community.
A second risk measure, standard deviation, looks instead at the volatility of a given financial instrument. It provides a range of expected returns based on past performance. For example, the S&P 500 since January 1, 1926, has a historical standard deviation of approximately twenty. This means that over that time frame, the S&P 500s returns fell within a range of 20% above and 20% below its historical mean approximately 10.7% two-thirds of the time. As a result, because it is more accurate as a gauge of portfolio volatility, it is generally used frequently to quantify risk for mutual funds and other such portfolios of securities.
Risk is manageable to a degree. However, you really cant avoid or minimize risk unless you understand the many types of risks there are and what they are.
For further information, contact Louis P. Stanasolovich, CFPÔ at (412) 635-9210 or e-mail him at email@example.com.