What is Risk?

What is Risk?

by Steven Lewis on Jan 8, 2015

Investment Risk

Risk is critical and must be respected when it comes to managing equities within a portfolio.  One cannot rely solely on what is commonly known as 'diversification' to solve the problem.  The problem with the typical approach to diversifying a portfolio with bonds, U.S. equities, emerging markets, etc., is that in many cases there is in many cases a  portion of the portfolio that is not working.  We do not operate like that.  We diversify to optimize returns.    
    
Risk is the measurable possibility of losing or not gaining in value.  Risk is differentiated from uncertainty, which is not measurable.  Among the commonly encountered types of risk encountered by investors are:  actuarial, asset class, currency, economic, financial, interest rate, liquidity, market, opportunity, purchasing power, reinvestment, and taxation.  Every investment that has ever existed and currently exists is subject to one or more forms of risk.

Standard Deviation is one of the fundamental measures of risk associated with an investment.  In its basic from, it describes how far from a security's expected return might the investment vary.  This assumes that the variation from the expected return follows a standard bell sharped curve (i.e. normal distribution).*  

The standard deviation measure is a statistic used to measure the dispersion (variation) of returns around an asset's average or expected return.  Standard deviation is the square root of variance.  Standard deviation is used to compare the degree of risk between investments.  Variance is also used for this purpose, but standard deviation is a more useful comparison tool and is more frequently used because smaller numbers are generally easier to work with and understand.* 

Below are those risks and their definitions:

Actuarial Risk
This is the type of risk an insurance underwriter covers in exchange for premiums.  The risk to the insurer is premature death.  Investors who have sufficient assets for the remainder of their lives have no real actuarial risk.  

Asset Class Risk
Stocks, bonds, and cash are the three major asset classes.  If you allocate too much of your wealth to any one of them, you may be subjecting yourself to what is known as asset-class risk.  The whole rationale behind mutual funds is the idea of diversification, or holding bunches of securities.  There is good reason for this.  Academic research has determined that with at least 12 and preferably 20 different stocks in a portfolio, investors can eliminate most company specific risks. 

Currency Risk
Sometimes referred to as "exchange risk," currency risk is the chance of loss on foreign currency exchange.  A U.S. investor who has no foreign holdings directly or indirectly (e.g., a global or international fund) is not subject to any kind of currency risk.  

Economic Risk
Economic risk is something associated with investing in developing countries.  It has to do with political instability and things such as government privatization or the economic collapse of and entire country.  For all practical purposes, only shareholders of emerging markets securities are subject to economic risk.

Financial Risk
Financial risk is something both U.S. and foreign investors face.  It refers to the likelihood of a corporation going bankrupt or not being able to pay its obligation.  Financial risk is perhaps the greatest risk faced by high-yield bond investors, particularly bonds rated below single B.

Interest Rate Risk
When interest rates increase, or there is the belief that they are going to rise, bonds and utilities drop in value.  Next to fuel costs, one of the largest expenses incurred by a utilities company is servicing debt.  Investors who own 30-year zero coupon bonds are subject to the greatest amount of interest rate risk.  Investors who own any kind of long-term bond are also exposed to a high level of interest rate risk, particularly if the bonds have comparatively low coupon rates.  Preferred stock, utility stock, and other high-dividend-paying common stock owners are also subject to a fair amount of interest rate risk.

Come by our office(s) and we will show you how we manage risk and how we will use CASH within the portfolio when it becomes incumbent on us to do so.    
 
Source:  Institute of Business and Finance Graduate Series Module V / *2014 Investment Management Consultants Association