Understanding Investment Risk
Hands down, the fourth quarter of 2008 and the first quarter of 2009 were trying times for those of us who were invested in the capital markets. While we tried to constrain our range of emotions, I remember thinking and sharing with my clients that the only silver lining was the severity of the situation. This meant that the United States Congress, the U.S. Treasury Department, and the U.S. Federal Reserve would have to act decisively in order to avoid a global economic catastrophe. On October 3, 2008, President George W. Bush signed into law the Troubled Asset Relief Program (TARP).
While it appears that the worst is behind us, the memories of the experience will be with us for years to come. When asked to define investment risk, most of my clients tend talk in terms of the irrevocable loss of principle. This definition would be plausible, provided they had invested into a specific security, such as the stock of their employer.
Investment risk is divided into two primary categories, unsystematic risk (specific risk) and systematic risk (market risk). Unsystematic risk is diversifiable whereas systematic risk is not diversifiable. Most of us have heard the phrase “don’t put all of your eggs into one basket”. This is the simple definition of diversification.
Unsystematic risk is risk that is specific to a company or an industry. Can you think of any industries or companies of the past that no longer exist today? What about Enron, Arthur Anderson, American Motors Corporation? What about products that once thrived but today are no longer relevant? Products like video the cassette recorder, Polaroid land camera (self-developing film), floppy disk, or telephone booth. Unsystematic risk is considered diversifiable. By choosing to increase the number of companies and industries that are invested in, the probability decreases that these industries and companies would all cease to exist at once.
Systematic risk is any risk associated with the overall economic market and is further defined by the following:
- Purchasing Power Risk: Inflation
- Reinvestment Risk: Reinvest at a lower interest rate”
- Interest Rate Risk: U.S. Federal Reserve increasing or decreasing the Fed Funds Rate
- Market Risk: Government economic policy or geo political factors
- Exchange Rate Risk: Depreciation or appreciation of differing countries currency
As stated earlier, systematic risk is associated with the overall economic markets and is not diversifiable. The challenge with systematic risk is the influence of macro-economic criteria such as gross domestic product (GDP), unemployment rates, oil prices, international trade policies, consumer spending, and many other areas of concern that lay beyond the direct control of any individual, company, or government.
Think of it this way. What would happen if the west coast experienced a prolonged severe drought that adversely impacts the supply of the nation’s fruits and vegetables? How would this effect the cost? What happens when the production of the world’s supply of oil is reduced? Gas prices increase and require a larger percentage of your income, reducing the amount of money available for you to spend on other necessities.
Everything that I have shared so far influences market volatility. When experiencing market volatility, many of us find it difficult to manage our emotions. In financial terms, volatility is measured by standard deviation, a term used to measure the dispersion around the mean.
For example, what is the probability of the outcome if you were to place $5,000 in a guaranteed account earning a fixed interest rate of 4%, compounded annually for fives year? Five years later, your $5,000 investment would be worth $6,083. What are your chances of this occurring? If you answered 100%, you are correct! Does your answer change if instead you decide to take your chances and purchase a stock that your friend recommends? Five years later, how much money will you have? Not a clue? Without fully understanding the volatility of the investment, it would be impossible to understand the potential range of returns.
While we all desire to maximize our investment returns, do we also not want to be compensated for the amount of risk taken? Why take unnecessary investment risk without being compensated for the risk? What is true for me, investments in the market is more about managing and mitigating risk then the desire of chasing returns. But then again, I, like everyone, have my own personal bias. Are you willing to put all of your money at risk?
