By Peter Pearce
Risk is one of the two central concepts of the investment process, but is a really dirty word for a lot of investors and a source of extraordinary stress. Too many have an exaggerated fear of risk; they irrationally believe that the stock market is treacherous and often equate risk to a probable large loss of principle. However risk cannot be avoided, and for long-term investors, a failure to assume reasonable risk guarantees they will never reach any reasonable financial objectives. A poor understanding of risk may prevent you from making rational choices and the biggest risk just might be being out of the market entirely! If you believe that your investments are entirely risk-free, then you’re fooling yourself and have traded one risk that you understand for another that you don’t. Success in your finances depends on your understanding of what risk really is and how to manage it in your portfolio, so let’s dive in and discuss some of the basic risk classes.
While we talk about the different classes of risk, remember that this is an introductory piece to discuss general risk factors, so if you came here looking for delta hedging strategies, turn back now. We won’t cover more advanced topics like risk sensitivities (ie. the Greeks) or using VaR to quantify risk.
I’ll divide our discussion of risk into the following classes, but this is just one way to slice up our risk pie.
- Business Risk: Risk that the company might fail and leave your stock or bond worthless.
- Market Risk: Also called systematic risk. Risk that a declining market will cause a decline in stock prices.
- Interest Rate Risk: Risk that changes in interest rates will cause the asset to decline in value.
- Political Risk: Risk that an investment’s returns change due to the government changing the country’s economic climate. Examples can vary from a war to raising taxes.
- Currency Risk: Risk that the value of your positions will change as exchange rates move.
When many common investors think of risk, they only consider business risk, but it's just one of many risks your portfolio faces. Each of these risks can be mitigated and the trick is to understand what level or risk your willing to accept, and manage your portfolio from there.
This is the first risk most investors consider because of some of the high profile failures over the last decade such as Lehman, WaMu and WorldCom. A business doesn’t need to fail for your asset to fall in value, it can come on hard times and fade as it loses a competitive advantage. Entire industries can find themselves unable to compete in a shifting global economy, just take a look at the newspaper industry.
Disasters can also strike at any time and completely upend an industry. Utility investors suddenly started evaluating their exposure to atomic energy following the catastrophe at the Fukushima Daiichi reactors this March. Greek bondholders endured a different type of business risk when they found that the Greek government had used fraudulent accounting and pushed the country to the brink of default. It seems that we live in an age where these “outlier” events that should never happen, occur with more and more regularity.
Investors have every right to be worried about these events but fortunately, this risk can be reduced to be insignificant through diversification. A single company might go broke, or an entire industry might be put out of business, but the entire market cannot.
As the number of positions that an investor holds increases, business risk falls quickly. Some textbooks claim that as few as 15-20 stocks offer adequate diversification and the risk reduction benefits after that reach a point of diminishing returns. However even the smallest of investors can hold mutual funds or ETF’s that offer an exposure to thousands of stocks.
You are never compensated for risks that could have been diversified away, and securities are priced based on the assumption that you hold a diversified portfolio. It’s important for you to understand that contrary to popular belief, the variation around the expected rate of return (ie. risk) falls as you increase the number of positions in your portfolio, but the level of expected return does not! Failure to diversify properly is an unforgivable investment mistake.
Market risk is the fluctuation in the market as a whole and no matter how many positions you hold, or what asset classes you hold, it won’t go away. It’s called systematic or “non-diversifiable” risk because no matter how well an individual company performs, its price will be affected by broad market trends. Few fish can swim against the current, and when the entire market tanks, every one of them follows. There are two ways to remove market risk, one is to exit the market entirely by closing your positions and the other is to hedge the market risk by using derivatives.
Market risk is primarily a short term concern and it falls when you increase the time-horizon of your investments. Someone who is investing for their child’s education in 15 years should not be too concerned if the investment value bounces day to day as stock prices have historically risen over longer time periods You can cut the volatility of your portfolio returns by investing money required to satisfy known obligations coming due in the next 5 years in more conservative investments like short term bonds or cash. I would suggest avoiding variable assets like stocks or long term bonds to avoid being in a position of having to liquidate those assets at a loss to cover an anticipated expense.
To hedge systematic risk, close your positions if you are able to do so without incurring a large loss. If you do not wish to close your positions, you will need to take the opposite side of your original trade or introduce uncorrelated assets like a bond fund. For example, if you are long the S&P500 with the SPDR S&P500 (SPY), buying put options on the SPY or shorting the SPY would be effective ways of temporarily eliminating market risk in those positions. This is a common strategy called portfolio insurance. It allows you the right to sell your stock or fund for a certain price in the future. For a more detailed description of this strategy, see our previous article, “Too Late to Protect Your Portfolio?”
Interest Rate Risk
Interest rate risk affects your assets in a couple of different ways.
Most importantly, the value of bonds are inversely related to the level of interest rates. I’ll illustrate a simple example, suppose you buy a bond at par with a coupon of 5%. If the interest rate subsequently increased to 6%, then no one would buy your bond at face value anymore, as they could buy one with a 6% coupon instead. You would have to cut the price of the bond below par until the discount you offered and the 5% coupon together made the yield equally attractive as the 6% bond. So as interest rates increased, the value of your bond decreased. The longer the remaining life of your bond, the more it will be affected by changes in interest rates. A bond with one week left until maturity would be almost unaffected by large changes in interest rates, while an identical bond with 30 years until maturity would see its value change violently. A bond trader convinced that interest rates were going to increase would shorten the length of his portfolio.
Another consideration of interest rate risk is the risk that you won’t be able to re-invest your principal when the bond matures at the rate you originally had. In the early 1980s, an interest rate of 15% was the norm, while in the early 90s, interest rates had fallen to about 6%, forcing those with maturing bonds to reinvest them at a much lower rate!
A last issue to keep in mind is that at lower levels of interest rates, changes in the level of interest rates will cause larger swings than when the level is high. For example, at current U.S interest rates of 2%, an increase of 1% to 3% would cause a large change in the value of all 2% bonds. However, suppose interest rates were at 15%, a 1% increase to 16% would cause a much smaller change in the value of the 15% bond than the 2% bond. This obviously isn’t an issue if you intend to hold your bonds until maturity.
Some stocks act very much like bonds during the interest rate cycle. Utilities and REITs are often purchased for their dividends by yield-hungry investors and therefore rising rates will tend to depress these stocks. The text-book answer for interest rate risk is to arrange a bond portfolio that staggers the maturities over time, that way the entire portfolio is not rolled over at one time, and the rates average out.
Governments at all levels have a tremendous impact on the economic climate of their area. While most typically associate political risk to international investing, it also includes changes in the investment climate at home. Political risks include poor trade, tax, regulation, education and social policies. A government’s ability to properly manage capital and the business environment sets the stage for the success of their economy. It can lead to disastrous consequences, such as the Russian default in 1998 or stunning economic successes like the U.S. in the 80s. Political risk can work to our advantage by finding countries where political risk is high but falling. In such a country, we would expect earnings in the economy to increase as the economic climate improved and the economy expanded. A final consideration would be that your foreign bonds could turn into unenforceable claims. In your home country, you have a specific legal recourse in the event of default by the counterparty. Foreign bonds offer no such protection and legal recourse could be much more expensive.
This current year abounds with great examples of political risk, such as the popular revolution in Egypt which overthrew the regime of Hosni Mubarak. Funds which had exposure to Egypt, such as the MarketVectors Egypt Fund (EGPT), were crushed when they stock market reopened in March after having been closed for 8 weeks. The EGPT fund is currently down 41.57% YTD. If the new governments ushered in by the Arab Spring impose positive economic reforms and introduce more stability, they could be good opportunities to invest and capture falling political risk.
Regardless of whether you choose to invest in foreign markets, you will be exposed to currency risk, it’s unavoidable. When the value of your local currency falls, you will lose purchasing power as goods you consume that are imported from abroad become more expensive This creates an incentive to invest internationally to partially hedge this effect.
International fixed income and equity are affected in a different manner when you hold investments denominated in a foreign currency, with bondholders being affected most dramatically.
I’ll illustrate with an example, if a Canadian were to purchase a U.S. bond at par, with an exchange rate at the time of C$1 per U$1, it would cost him C$1,000. Suppose the exchange rate drops to C$.8 per U$1 in a couple of years when the bond matures. The Canadian investor would receive a principal payment valued at C$800 which he originally paid C$1000 for! That’s quite a dramatic loss on principal and would offset any gains made by the coupon payments. The effect on stocks is more ambiguous, as it would depend on whether the company is a net importer or exporter.
Currency risk therefore can have quite dramatic effects on your portfolio returns, as gains can be offset by losses in currency, or losses further compounded. Deciding whether to hedge currency risk is the key and the field of finance is sharply divided on this subject. Some academic studies have come out saying the price of hedging isn’t worth the benefit as forecast are difficult while others explain that proper forecasts add value while reducing risk. I leave the conclusion to this debate to the academics. If you’re unwilling to expose yourself to these currency fluctuations, there are investments available such as WisdomTree International Hedged Equity Fund (HEDJ) which uses derivatives to smooth out the currency risk in the ETF. A previous article by Efficient Alpha also explored the concept of emerging market investments as a means of protecting dollar investors’ purchasing power.
I hope that this brief discussion or risk has added another tool to your investment toolbox to use in controlling which risks you want to be exposed to, and which you don’t.
A final note on factors that multiply risk: A lack of diversification, excessive use of leverage or using derivatives to speculate instead of hedge will all multiply your level of risk. If you are a novice in investing or are investing for the long-term, I would avoid falling into these traps.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.