Iden­ti­fy­ing the many kinds of in­vest­ment risks

The Saratogian (Saratoga, NY) - - BUSINESS - Chris + Den­nis Fa­gan

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.

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