Understanding Investment Risk
Investment risk is the likelihood of a loss occurring in relation to the anticipated return of any investment. When the risk of an investment is high, investors typically seek higher returns to compensate for taking this level of risk.
Different investments have different risks and returns. These differences often relate to the liquidity of the investment (how quickly investors can get their money from the investment when needed), the safety of the investment, and how rapidly their investment is likely to increase in value.
The importance of risk measurement
Before investing, it’s important to understand what is investment risk, how much risk you need to take, and how much you are prepared to tolerate to meet your investment goals.
There’s a saying in investing that “time in the market beats timing the market.” Generally, younger investors can take more risks because they can stay invested long enough for the markets to recover from a sharp downturn.
That doesn’t mean that older investors should shun risk entirely. They should still have some exposure to the stock market. Otherwise, their portfolios might not keep up with inflation.
Measuring risk is also important because it takes into account your personality. Some personality types can cope with stomach-turning downturns in the stock market; others can’t.
Your goals determine the amount of risk you can prudently take. A competent advisor will consider your investment objectives (preservation of capital, generating income, or growth) to evaluate your risk tolerance (the level of risk of loss you are willing and able to take to achieve your investment goals).
Categories of Risk
There are six broad categories of risks investors should understand:
1. Business risk
2. Volatility risk
3. Inflation risk
4. Interest rate risk
5. Liquidity risk
6. Systemic risk
“Business risk” refers to the risk of an adverse change in the financial condition of the company you have invested in. Whether you purchase a stock or a bond, your investment outcome will depend on the viability of the company issuing those securities.
If the company declares bankruptcy, stock owners are the last in line to receive proceeds. Bondholders will be paid before shareholders, but they still may incur losses.
“Volatility risk” refers to market fluctuations, which can be dramatic and sudden. Some investors are not psychologically prepared to “weather the storm” and stay the course during periods of extreme volatility.
Interest rate risk
“Interest rate risk” applies primarily to holders of bonds. If you want to sell your bonds before maturity and interest rates have increased to a level higher than your bond is paying, you might have to sell at a discount.
“Inflation risk” refers to the erosion of purchasing power caused by inflation. If the return on your stocks or bonds is lower than the inflation rate, this loss of purchasing power can seriously impact your quality of life over time.
“Liquidity risk” refers to an inability to convert your holdings into cash when you wish to do so.
Some investments may require you to hold them for a particular time. Others may charge a penalty for early withdrawal. Some complicated investment products may be thinly traded, so there may be no buyers when you want to sell.
“Systemic risk” refers to factors that can impact the stock market as a whole and are beyond the control of investors. Examples of systemic risk include geo-political events, major weather events, terrorism, and inflation.
How risk is measured
The five principal used to assess the level of risk in any investment are:
4. Standard deviation
5. Sharpe Ratio
An investment professional will typically use these measures of risk either by themselves or together when performing a risk assessment.
“Alpha” measures the risk relative to the overall market or a certain benchmark index.
If the S&P 500 is the benchmark for a particular mutual fund, that fund’s performance would be compared to the performance of the S&P 500. Outperforming the S&P 500 means the fund gets a positive alpha, while underperforming gives it a negative alpha.
A beta score of 1 means the fund will likely move in lockstep with the benchmark. A score below 1 means it’s less volatile than the benchmark. Lastly, a score over 1 means it’s more volatile.
Morningstar “R-squared” as a calculation that measures “the relationship between a portfolio and its benchmark index.”
Investors who want a portfolio that moves in tandem with the designated benchmark should seek a high R-squared score, with 100 being the highest.
“Standard deviation” the volatility of a stock, bond, fund, or other investment.
A higher standard deviation indicates greater volatility, which could mean a mutual fund’s performance varied significantly either above or below its average annual return.
The Sharpe ratio measures the risk-adjusted return of a financial portfolio. It calculates the measure of excess portfolio return over the risk-free rate relative to its standard deviation.
The Sharpe ratio assists investors in determining whether they are adequately compensated for assuming great risk by higher returns. Investments with a high Sharpe ratio are attractive because of the relationship between the return earned and the risk taken.
Takeaway on risk measurement
Knowing what is investment risk entails measuring, and measuring risk is the “critical first step towards managing it.” Some experts believe managing the trade-off between risk and return “is the foundation of successful investing.”
While your focus may be on the expected returns of your investments, it’s the responsibility of your registered investment advisor to focus intensely on risk and give you tools for managing it. Commonly used risk mitigation tools ensure your portfolio is globally diversified and properly allocating your holdings between stocks, bonds, and cash.
Some experts believe managing the trade-off between risk and return “is the foundation of successful investing.”
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