What is Risk?
Risk takes on many forms but is broadly categorized as the chance an outcome or investment's actual return will differ from the expected outcome or return. Risk includes the possibility of losing some or all of the original investment. Different versions of risk are usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.
While mathematically risk is symmetrical, most people only consider downside risk.
Understanding Risk And Time Horizon
The Basics of Risk
A high standard deviation indicates a high degree of risk. Many companies allocate large amounts of money and time in developing risk management strategies to help manage risks associated with their business and investment dealings. A key component of the risk management process is risk assessment, which involves the determination of the risks surrounding a business or investment.
A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an investor is willing to take, the greater the potential return. Investors need to be compensated for taking on additional risk. For example, a U.S. Treasury bond is considered one of the safest, or risk-free, investments and when compared to a corporate bond, provides a lower rate of return. A corporation is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher, investors are offered a higher rate of return.
There are several ways to measure risk, such as downside deviations, Roy's safety first ratio, and portfolio standard deviation. Measuring risk allows investors and traders to hedge some of that risk away using various strategies including employing derivatives positions.
Individuals also have their own willingness and ability to take risk (risk-tolerance) based on objective factors like income and age as well as subjective factors like personality, personal experience, and emotion.
- Risk takes on many forms but is broadly categorized as the chance an outcome or investment's actual return will differ from the expected outcome or return.
- Risk includes the possibility of losing some or all of the original investment.
- There are several ways to quantify risk including standard deviation, VaR, and the safety-first ratio.
- Risk can be reduced using hedging strategies to insure against some losses.
On the other end of the investment spectrum, ultra-conservative investors avoid any type of risk to principal whatsoever. These types of investors seek safety and insured holdings such as bank certificates of deposits (CDs), whose one-year interest rate averages approximately 1.25% as of June 2016. Bank deposits are also insured by the Federal Deposit Insurance Corporation (FDIC), an agency created to maintain consumer confidence in the U.S. banking system.
U.S. Treasury's, backed by the full faith and credit of the U.S. government, also appeal to risk-averse investors. The three-month Treasury bill is considered a riskless security and is measured against securities that hold higher measures of volatility. As of July 1, 2016, the 91-day T-bill, purchased at a discount to par value, has a yield to maturity of 0.27%.
While considered "riskless" all assets - even U.S. government debt - has some, albeit very small, level of riskiness.
Morningstar Risk Ratings
Morningstar is one of the premier objective agencies that affixes risk ratings to mutual funds and exchange-traded funds (ETF). An investor can match a portfolio’s risk profile with his own appetite for risk. Highly volatile precious metal ETFs such as the Global X Gold Explorers ETF receive a high risk rating from Morningstar as the fund invests 48% of its holdings in international gold mining companies. The highly volatile fund holds a three-year standard deviation of 59.02 when compared to the Morgan Stanley Capital Index (MSCI) All Country World Index, whose measure is 11.82. Risk-hungry investors were rewarded with a 2016 year-to-date (YTD) return of 140.17% through June 30, 2016.
Types of Financial Risk
Market risk and specific risk are two different forms of risk that affect assets. All investment assets can be separated by two categories: systematic risk and unsystematic risk. Market risk, or systematic risk, affects a large number of asset classes, whereas specific risk, or unsystematic risk, only affects an industry or particular company.
Systematic risk is the risk of losing investments due to factors, such as political risk and macroeconomic risk, that affect the performance of the overall market. Market risk is also known as volatility and can be measured using beta. Beta is a measure of an investment's systematic risk relative to the overall market.
Market risk cannot be mitigated through portfolio diversification. However, an investor can hedge against systematic risk. A hedge is an offsetting investment used to reduce the risk in an asset. For example, suppose an investor fears a global recession affecting the economy over the next six months due to weakness in gross domestic product growth. The investor is long multiple stocks and can mitigate some of the market risk by buying put options in the market.
Specific risk, or diversifiable risk, is the risk of losing an investment due to company or industry-specific hazard. Unlike systematic risk, an investor can only mitigate against unsystematic risk through diversification. An investor uses diversification to manage risk by investing in a variety of assets. He can use the beta of each stock to create a diversified portfolio.
For example, suppose an investor has a portfolio of oil stocks with a beta of 2. Since the market's beta is always 1, the portfolio is theoretically 100% more volatile than the market. Therefore, if the market has a 1% move up or down, the portfolio will move up or down 2%. There is risk associated with the whole sector due to the increase in supply of oil in the Middle East, which has caused oil to fall in price over the past few months. If the trend continues, the portfolio will experience a significant drop in value. However, the investor can diversify this risk since it is industry-specific.
The investor can use diversification and allocate his fund into different sectors that are negatively correlated with the oil sector to mitigate the risk. For example, the airlines and casino gaming sectors are good assets to invest in for a portfolio that is highly exposed to the oil sector. Generally, as the value of the oil sector falls, the values of the airlines and casino gaming sectors rise, and vice versa. Since airline and casino gaming stocks are negatively correlated and have negative betas in relation to the oil sector, the investor reduces the risks that affect his portfolio of oil stocks.
Business risk refers to the basic viability of a business—the question of whether a company will be able to make sufficient sales and generate sufficient revenues to cover its operational expenses and turn a profit. While financial risk is concerned with the costs of financing, business risk is concerned with all the other expenses a business must cover to remain operational and functioning. These expenses include salaries, production costs, facility rent, and office and administrative expenses. The level of a company's business risk is influenced by factors such as the cost of goods, profit margins, competition, and the overall level of demand for the products or services that it sells.
Credit or Default Risk
Credit risk is the risk that a borrower will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is particularly concerning to investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal government, have the least amount of default risk and, as such, the lowest returns. Corporate bonds, on the other hand, tend to have the highest amount of default risk, but also higher interest rates. Bonds with a lower chance of default are considered investment grade, while bonds with higher chances are considered junk bonds. Investors can use bond rating agencies – such as Standard and Poor’s, Fitch and Moody's – to determine which bonds are investment-grade and which are junk. (See also: Corporate Bonds: An Introduction to Credit Risk)
Country risk refers to the risk that a country won't be able to honor its financial commitments. When a country defaults on its obligations, it can harm the performance of all other financial instruments in that country – as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit. (See also: The Risks of Investing in Emerging Markets)
When investing in foreign countries, it’s important to consider the fact that currency exchange rates can change the price of the asset as well. Foreign exchange risk (or exchange rate risk) applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you live in the U.S. and invest in a Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the U.S. dollar. (For related reading, see: How to Avoid Exchange Rate Risk)
Interest Rate Risk
Interest rate risk is the risk that an investment's value will change due to a change in the absolute level of interest rates, the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. This type of risk affects the value of bonds more directly than stocks and is a significant risk to all bondholders. As interest rates rise, bond prices fall – and vice versa. (For more, see: Managing Interest Rate Risk)
Political risk is the risk an investment’s returns could suffer because of political instability or changes in a country. This type of risk can stem from a change in government, legislative bodies, other foreign policy makers or military control. Also known as geopolitical risk, the risk becomes more of a factor as an investment’s time horizon gets longer. (See also: What is Political Risk and What Can a Multinational Company do to Minimize Exposure?)
Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions, espcially for those occurring in over-the-counter (OTC) markets. Financial investment products such as stocks, options, bonds, and derivatives carry counterparty risk. Bonds are rated by agencies, such as Moody's and Standard and Poor's, from AAA to junk bond status to gauge the level of counterparty risk. Bonds that carry higher counterparty risk pay higher yields.
Risk vs. Uncertainty
Risk is defined as a calculable probability of loss, such as a standard deviation or using a technique such as value at risk (VaR). The likelihood of a poor outcome such as a loss can thus be assigned a probability and quantified. Because it is measurable and probabilistic, risk can be hedged or insured against, and so reduced.
Uncertainty, on the other hand, refers to circumstances where the outcomes or potential probabilities for a loss are unknown and unknowable. Because uncertainty cannot be calculated it cannot be fully hedged against. The distinction between risk and uncertainty can be attributed to the economists John Maynard Keynes and Frank Knight.
Risk vs. Reward
The risk-return tradeoff is the balance between the desire for the lowest possible risk and the highest possible returns. In general, low levels of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty (high risk) are associated with high potential returns.
Each investor must decide how much risk they’re willing and able to accept for a desired return. This will be based on factors such as age, income, investment goals and personality. It’s important to decide how much risk you can take on while still remaining comfortable with your investments: Too little risk and your earnings will suffer; too much risk and you won’t be able to sleep at night. The key is to find the balance where your earnings are acceptable and you’re not outside your comfort zone.