Understanding Risk—Section 3
In order to select investments with the right balance between risk and return, you first need to understand what constitutes a risk. There are many different types of risk; some are obvious while others are more subtle. They all, however, fall into two broad categories which are asystemic risk and systemic risk.
Asystemic risks are those risks that are specific to a particular stock or bond. Systemic risks are risks arising due to broad economic forces that effect entire industries or even entire investment classes, such as U.S. stocks or bonds.
Examples of Asystemic Risk
Business Risk
A company in which you own stock declares bankruptcy. Should this occur, you would probably lose your entire investment.
Valuation Risk
You purchase stock in a company that appears to be doing well. Later news is released that causes the company’s stock to lose half of its value in a matter of hours. The stock may eventually recover, but this could take years.
Liquidity Risk
This occurs when you want to sell something but nobody else wants to buy it. You may eventually be able to sell it but not at a price that you would consider fair. In the financial market this may happen with very small companies or with companies whose stock is only infrequently traded. This is generally not a concern with exchange traded or NASDAQ listed stocks.
Credit Risk
If a company’s credit rating is downgraded, both its stocks and bonds will decline. A credit rating downgrade means that the company is less able to meet its financial obligations and that there may be serious internal problems.
Examples of Systemic Risk
Inflation Risk
Inflation occurs when the value of a currency declines in relation to the cost of goods and services. Over time, more currency is required to purchase the same item or service.
A moderate level of inflation appears to be part of the cost of running a modern economy, so you can expect it to be with us for the foreseeable future. Inflation must be factored in when estimating your investment returns. If inflation is at 3% and your investment earnings are 5%, your real inflation adjusted return is only 2%. This is one reason why maximizing your long term return is so important. If you avoid assuming any risk at all, your investment return may be so low that you have difficulty keeping pace with inflation.
Interest Rate Risk
The cost of money drives every aspect of business and personal finance. The most immediate effect of changes in prevailing interest rates is on bond prices. As interest rates go up, the price of bonds go down and when interest rates go down, the price of bonds go up. These price fluctuations are usually minor, but there have been periods, such as during the early 1980s, when bond price fluctuations were substantial.
Industry Risk
Entire sectors and industries become more or less profitable over time due to changing economic conditions. Companies in the same industries sell similar products or services to the same type of customers. If the demand for the products of that industry decline or the cost of producing these products increases, all companies in the industry will to varying degrees be affected.
Market Risk
During a bull market (rising market) the majority of stocks increase in value. During a bear market (declining market) the majority of stocks decrease in value. Major market swings are the result of economic factors that affect the entire U.S. economy. For example, during recessionary periods, most companies become less profitable because there is reduced business activity. This is reflected in the form of lower stock prices.
Most asystemic risk can be controlled through a sufficient level of diversification. For example, if you own stock in 100 different companies and one company experiences severe problems, its effect on your portfolio should be small because it only involves 1% of your holdings as long as the 100 are diversified.
To a lesser degree, systemic risk can also be controlled through diversification. Spreading your investments over many sectors and industries will reduce industry risk. While one industry is fading, another may be taking off. Interest rate risk can be controlled by purchasing bonds with different maturity dates (see section 7). Market risk can be managed by diversifying among different asset classes such as stocks, bonds and cash. Market risk can also be controlled by leaving the market when it appears likely the primary trend of the market has shifted from up to down and reentering the market when it appears likely that the primary market trend has shifted from down to up (see section 13).
The easiest way to achieve diversification is by investing in mutual funds. Each fund typically invests in dozens of individual securities. If you invest in several mutual funds with different investment objectives, you can achieve a high level of diversification with a very small investment. Stock based mutual funds are discussed in our next section.
Quiz Section 3
1. You own shares in a company that loses a major lawsuit. Its stock loses half of its value in a matter of minutes but the company will remain in business. This is an example of:
A) Interest Rate Risk
B) Systemic Risk
C) Valuation Risk
D) Market Risk
2. You invest all of your savings in a U.S. Government Money Market Fund yielding 3%. The current inflation rate is 3.25%. In this situation you are most subject to:
A) Business Risk
B) Inflation Risk
C) Credit Risk
D) Interest Rate Risk
3. 80% of your stock holdings are in oil producing companies. What is the greatest risk that you are assuming:
A) Industry Risk
B) Credit Risk
C) Interest Rate Risk
D) Inflation Risk
4. You own 5 broadly diversified stock based mutual funds with different investment objectives. What is your major risk?
A) Industry Risk
B) Business Risk
C) Market Risk
D) Credit Risk
5. Diversification can reduce which type of risk?
A) Asystemic Risk
B) Systemic Risk
C) Both
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