We all face risks every day—whether we’re driving to work, crossing the road, managing a business, or investing.
Investment risk can be defined as the probability of loss or achieving lower-than expected returns from an investment. However, risk is such a widely mis-used word in investment management and is often disclosed away in documents which are rarely read. At the end of the day risk is different depending on the individual. In this article we attempt to explore some of the different risks to consider when investing and to understand what risks matter to you.
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so. “
Mark Twain
What is Risk Free?
A risk-free investment does not exist, but there is a spectrum between being low risk and high risk. Even cash held with a financially secure bank is exposed to inflation and counterparty risk.
Even keeping hard cash under the mattress is exposed to physical risks (fire, theft) as well as inflation risk. Cash rarely keeps pace with inflation and is therefore not a good store of wealth to meet your future needs.
How do you measure risk?
A commonly used measure of risk in the investment world is to look at the past annualised volatility of an investment. Volatility is a measure of how widely an investment’s returns have varied from its own average return over a particular period of time. For example, if an investment had an average annual return of 5% over the past 7 years and its volatility was 10%, the range of annual returns over the 7 year period would have been between +15% and -5%. Volatility is a statistical measure of the dispersion of returns for a given security or market index. Volatility is often measured as either the standard deviation or variance of returns from that same security or market index.
Tracking Error is another term often seen used. This is simply the variability of an investment or fund’s return relative to its reference index or benchmarks. To further complicate matters Tracking Error can be ex-poste (backward looking) or ex-ante (forward looking) and there are a multitude of other ways to quantify risk – Sharpe Ratio, Beta, Value at Risk (VaR), R-squared and many more.
The Risk/Return Trade-off
The theory of risk and return (or reward) is simply that for every unit of risk a person takes, they should be rewarded with the potential to achieve higher returns. You can think about taking on more risk as payment for increasing the potential to achieve higher future returns. This theory does not always play out, but it is a good rule of thumb to have when making an investment.
A basic example would be the decision of whether a person keeps their money in cash or invests into the shares of a single small company. The cash is a relatively low risk option and it will achieve relatively low returns, whereas purchasing a share in a small company has the potential to make very large returns, but comes with the risk of potentially going to zero.
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, liquidity needs, time horizon, and personality.
Read here about the potential impact of Total Return Swaps.
A simple visualisation of the relationship follows, although the relationship is neither a straight line nor static, but we might explore that another time.
As noted previously there is no risk-free return available, however cash at bank is the closest proxy. Therefore, the risk-reward trade-off is typically measured using cash as the starting point, i.e. what return do I require over and above the cash rate to compensate me for the risk I am taking.
Types of Financial Risk
Financial theory suggests investment and savings are broadly exposed to two risks, market risk (systematic) and specific (unsystematic) risk.
- Systematic Risk: Also referred to as market risk, is where an investor experiences losses because of factors that affect the overall performance of the financial markets and therefore cannot be eliminated by diversification. Other common types of systematic risk can include negative investor sentiment, interest rate risk, inflation risk, currency risk, liquidity risk, country risk, natural disaster, recession, economic impacts, and socio-political risk that affect market performance. Different asset classes have different levels of market risk.
- Unsystematic Risk: Also referred to as specific or idiosyncratic risk, is the risk associated with a single issuer of a security. Specifically, it is the possibility that an issuer may fail entirely or be unable to pay the interest or principal in the case of bonds. This risk can be mitigated through the use of diversification. Examples include a change in management, a product recall, a regulatory change that could drive down company sales, and a new competitor in the marketplace with the potential to take away market share from a company.
In addition to the broad systematic and unsystematic risks, there are several specific types of investment risk.
Read here about the need to be aware of specific investment risks.
Types of Investment Risk
- Cash Risk
- Concentration Risk
- Counterparty Risk
- Country Risk
- Credit or Default Risk
- Currency Risk
- Derivatives Risk
- Emerging Markets Risk
- Fund Manager Risk
- Hedging Risk
- Inflation Risk
- Interest Rate Risk
- Leverage Risk
- Liquidity Risk
- Market Timing Risk
- Opportunity cost
- Political Risk
- Regulatory Risk
- Short Selling Risk
- Unlisted Asset Risk
How can I diversify risk?
There are however ways to balance the risk return trade-off in your favour using tools such as diversification and investing over a longer period of time. All investments carry an element of risk which may vary significantly.
Although diversification will not ensure gains or guarantee against losses, it does provide the potential to improve returns based on your target level of risk, or goals. By investing in a range of investments with different characteristics and exposures you can reduce your overall risk and if desired, diversify away the unsystematic risk.
“Diversification is the only free lunch in finance”
Harry Markowitz (Nobel Prize laureate)
A well-diversified portfolio will consist of different types of investments that have varying degrees of risk and correlation with each other. You can diversify by investment vehicles (cash, shares, bonds, funds, ETFs etc.), assets whose returns haven’t historically moved in the same direction (typically shares and bonds), investment type (sector, industry, region, and market capitalization), in broader markets you can also consider different styles (growth, value etc.) and in the fixed income space (maturity, credit quality, fixed/floating etc.).
At the other end of the spectrum some investors prefer to concentrate their bets to achieve greater returns. The argument being that too much diversification simply gives you the return of the market.
With no risk there is no return. You should always remember that the value of your investments and any income from them can go down as well as up and you may get back less than the amount you originally invested. The key is to be aware of the risks you are taking, diversify where appropriate and manage them in line with your overall goals.
Source: adapted from Investopedia and CFA Institute.
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