"Risk is always all around us; we can’t run away from it nor hide from it. Though we may not be able to control the financial markets, risk is something we can manage."
— Rand M. Walker
A thorough understanding of the true nature of risk and its impact on results is critical if investors are to successfully meet their goals. Far too many institutional and individual investors tend to overestimate their investment returns and underestimate their exposure to risk.
RISK is defined as exposure to danger, harm, injury or loss as well as uncertainty of outcome.
We ought to keep well in mind that there is no such thing as a totally risk-free investment. Before we invest we must clearly articulate what our goals are, determine what we expect our investments to accomplish, and agree on how much risk we are willing to tolerate to reach our objectives.
Most of us tend to view the potential loss of value of our investments as the only risk worth focusing on, regarding any other type of risk as less consequential. As an example, cash, CDs and Treasury bills are oftentimes considered to be "safe" investments yet inflation could significantly erode their purchasing power, thus elevating their level of risk and making cash, CDs and Treasury bills less attractive as potential stores of value.
It’s been said that there are as many types of risk as there are grains of sand; while that may be so, the types of risk that concern us as investment managers are far fewer and easier to recognize. The most common ones are:
Market risk – price gyrations in the financial markets may cause us to lose some, or even all, of our capital.
Credit risk – financial problems may cause issuers of fixed income securities (i.e. bonds, preferred stocks) to forgo or delay payment of interest or dividends and/or repayment of principal.
Inflation risk – loss of purchasing power (i.e. an item that we bought yesterday at a lower price costs much more today).
Interest rate risk – interest-sensitive securities decline in face value as interest rates rise; conversely, as interest rates decline, their face value rises.
Reinvestment risk – inability to invest cash proceeds from maturing or called fixed income securities at rates as attractive as before.
Liquidity risk – inability to timely complete a transaction (i.e. can't find buyers or sellers for securities that we wish to sell or buy).
Redemption risk – issuers of a fixed income security may force us to redeem the security at an inopportune time.
Political risk – government seizes one’s assets or restricts access to them.
Currency risk – a currency loses or gains value relative to another currency.
Convertibility risk – inability to exchange one currency for another.
Risk is not to be feared; it ought to be understood... and managed! Successful investors don’t run away from risk; they manage it through a combination of:
Avoidance – it's possible to avoid SOME risks (i.e. not buying stocks or bonds avoids market risk) but no one can avoid ALL risks.
Assumption – by buying stocks or bonds we deliberately assume market risk and accept its consequences.
Diversification – we dilute our exposure to risk by spreading it around (i.e. not putting all eggs in the same basket). We must keep in mind, however, that proper diversification requires investing in securities that are NOT correlated with one another. The old adage that bonds are "less risky" or "safer" than stocks, is not necessarily true: while some government bonds are negatively correlated to stocks, corporate bonds and stocks generally tend to be highly correlated.
Transfer of risk – put and call options, when used properly, may be tools with which to transfer risk to another party; likewise, when we buy an insurance policy we effectively transfer our risk to the insurance company.
It's essential that prior to investing we clearly understand and distinguish those factors that WE CAN control (why, how, and where to invest) from those that WE CAN’T control (the economy, inflation, interest rates, tax rates, etc.) and be guided accordingly.