Identifying the many kinds of investment risks
Many investors associate risk with a loss of principal and indeed that is one definition of risk. However, there are many others, some of which we shall outline below that may be helpful in how you allocate your capital. Some risks are specific to investments in equities, some to fixed income (bond) while other risks are assumed by both equity and bond investors.
If one were to broaden out the definition of risk slightly, included would be systematic risk or the risk associated with an entire asset class such as stocks, bonds, cash, real estate or commodities. This type of risk is undiversifiable as it is associated with every investment within that asset class.
Another form of undiversifiable risk is investment risk or the risk that actual returns are less than expected returns as well as historical returns. For example, if over the past fifty years, including dividends the stock market averaged 9.00 percent per year and that was your expected return, any potential shortfall would be defined as investment risk.
Hypothetically, consider an investment of all of your money intended for equities into one stock – Philip Morris, a global manufacturer and seller of cigarettes as well as other tobacco products. In addition to the two detailed above, what risks would you assume? First and foremost, you would assume company specific risk or the risk that the share price of Philip Morris does not perform at or above that of its peers or a broad index of stocks such as the S&P 500. Something could occur to heighten this risk to include the untimely death of a member of senior management or perhaps some sort of inappropriate accounting issue. (Keep in mind this is purely hypothetical.) In addition to this risk, investors assume industry specific risk which could include those that are political, geopolitical or legislative in nature. For example, a government could place onerous restrictions or taxes on the product thereby negatively impacting revenue and/or profit margins.
The risks outlined within the paragraph immediately above are diversifiable as investors can allocate the capital that they have earmarked for the equity market across many different companies and operating in many different industries. This will not eliminate these risks but rather reduce the overall impact of a negative event.
It is also important to note that company and industry specific risks can pertain to fixed income as well as equities. For example, a law legislating higher taxes could result in a lower credit rating for the bonds of a company that sells cigarettes. This in turn will drive up the cost of borrowing, once again negatively impacting profitability and perhaps the long-term viability of said company.
Let’s now address some of the risks associated with fixed income of which the potentially most devastating would be the risk of default. Keep in mind that bonds are backed by the issuer so if the issuer lacks the ability to repay the debt the bond will default potentially leaving the investor to receive pennies on the dollar. This occurs most often during a bankruptcy or restructuring. It is important for risk adverse investors to diversify the vast majority of their bond holdings amongst a portfolio of companies with at least an investment grade credit rating along with bonds issued by and backed by the full faith and credit of the United States government.
Not always a catastrophic risk as compared to an imminent risk of default is credit quality risk or the risk that the cost of corporate borrowing will spike due to a downgrading of the debt of the issuer by a major credit rating agency such as Standard & Poor’s, Moody’s or Fitch as a result of negative company specific, industry, political, geopolitical, or legislative developments. Most often this will also negatively impact the price of existing debt.
The final risk to be addressed as part of this column is interest rate risk to be defined as the negative fluctuation in the price of a bond due to a rise in the direction of interest rates. Generally speaking, the price of longer-dated maturities fluctuate greater than similar shorter-dated ones. . After all, who would pay full value for a bond with a coupon of 2.25 percent if they could purchase one of the same issuer with a similar maturity for 3.25 percent? Please note that all data is for general information purposes only and not meant as specific recommendations. The opinions of the authors are not a recommendation to buy or sell the stock, bond market or any security contained therein. Securities contain risks and fluctuations in principal will occur. Please research any investment thoroughly prior to committing money or consult with your financial adviser. Please note that Fagan Associates, Inc. or related persons buy or sell for itself securities that it also recommends to clients. Consult with your financial adviser prior to making any changes to your portfolio. To contact Fagan Associates, Please call 518-279-1044.