| Investment-related Risk Believe it or not, one of the biggest investment risks is not investing at
all. Thinking of replacing your income at a later date or even reaching some of
your financial goals can be a daunting task. Without getting your hard earned
money to work for you makes reaching your goals even harder. The risk of
outliving your assets because you did not work to make them grow through
investing is really the biggest risk of all.
Risk Avoidance
| Investment planning is almost
impossible without a thorough understanding of risk. There is a
risk/return trade-off. That is, the greater risk accepted, the greater
must be the potential return as reward for committing one’s funds to an
uncertain outcome. Generally, as the level of risk rises, the rate of
return should also rise, and vice versa. Before we discuss risk in
detail, we should first explain that risk can be perceived, defined and
handled in a multitude of ways. One way to handle risk is to avoid it.
Risk avoidance occurs when one chooses to completely avoid the activity
the risk is associated with. An example would be the risk of being
injured while driving an automobile. By choosing not to drive a person
could avoid that risk altogether. Obviously, life presents some risks
that cannot be avoided. One may view a risk in eating food that might be
toxic. Complete avoidance, by refusing to eat at all, would create the
inevitable outcome of death, so in this case, avoidance is not a viable
choice. In the investment world, avoidance of some risk is deemed to be
possible through the act of investing in "risk-free" investments.
Short-term maturity United States government bonds are usually equated
with a "risk-free" rate of return. Stock market risk can be completely
avoided by one choosing to have no exposure to it by not investing in
equity securities. |
Risk Transfer
| Another way to handle risk is to
transfer the risk. An easy to understand example of risk transfer is the
concept of insurance.
If one has the risk of becoming severely ill (and unfortunately we all
do), then health insurance is advisable. An insurance company will allow
you to transfer the risk of large medical bills to them in exchange for
a fee called an insurance premium. The company knows that statistically,
if they collect enough premiums and have a large enough pool of insureds,
they can pay the costs of the minority who will require extensive
medical treatment and have enough left over to record a profit. Risk
transfer can also occur in investing. One may choose to purchase a
municipal bond that is insured. One may purchase a put option on a stock
which allows that person to "put to" or sell to someone their stock at a
set price, regardless of how much lower the stock may drop. There are
many examples of risk transfer in the area of investing. |
Risk Averse Investors
| Do investors dislike risk? In
economics in general, and investments in particular, the standard
assumption is that investors are rational. Rational investors prefer
certainty to uncertainty. It is easy to say that investors dislike risk,
but more precisely, we should say that investors are risk averse. A
risk-averse investor is one who will not assume risk simply for its own
sake and will not incur any given level of risk unless there is an
expectation of adequate compensation for having done so. Note carefully
that it is not irrational to assume risk, even very large risk, as long
as we expect to be compensated for it. In fact, investors cannot
reasonably expect to earn larger returns without assuming larger risks.
Investors deal with risk by choosing (implicitly or explicitly) the
amount of risk they are willing to incur. Some investors choose to incur
high levels of risk with the expectation of high levels of return. Other
investors are unwilling to assume much risk, and they should not expect
to earn large returns.
We have said that investors would like to maximize their returns. Can
we also say that investors, in general, will choose to minimize their
risks? No! The reason is that there are costs to minimizing the risk,
specifically a lower expected return. Taken to its logical conclusion,
the minimization of risk would result in everyone holding risk-free
assets such as savings accounts and Treasury bills. Thus, we need to
think in terms of the expected return/risk trade-off that results from
the direct relationship between the risk and the expected return of an
investment. |
Time and Risk
| Investors need to think about
the time period involved in their investment plans. The objectives being
pursued may require a policy statement that speaks to specific planning
horizons. In the case of an individual investor this could be a year or
two in anticipation of a down payment on a home purchase or a lifetime
if planning for retirement. Generally speaking, the longer the time
horizon the more risk can be incorporated into the financial planning.
The U.S. Department of Labor, Pension and Welfare Benefits
Administration states that since 1926, the average annual return of
short-term U.S, Treasury bills, which roughly equals the return of other
cash equivalents such as saving accounts, has been 3.8 percent. The
annual return of long-term government bonds over the same period has
been 5.3 percent. Large-company stocks, on the other hand, have averaged
an annual return of 11.2 percent. With these statistics available why
wouldn’t everyone at all times be 100 percent invested in stocks? The
answer is, of course, that while over the long term stocks have
outperformed, there have been many short term periods in which they have
underperformed, and in fact, have had negative returns. Exactly when
short term periods of underperformance will occur is unknown and thus
there is more risk in owning stocks if one has a short term horizon than
if there exists a long term horizon.
Time has a different effect when analyzing the risk of owning fixed
income securities, such as bonds. There is more risk associated with
holding a bond long term than short term because of the uncertainty of
future inflation and interest rate levels. If one were to "lock in" a
rate of 6 percent for a bond that matured in one year, an upward move in
inflation or interest rates would have a less adverse effect on the
price of that bond than a 6 percent bond that matured in thirty years.
That is because the bond could be redeemed in one year and reinvested in
a bond with a presumably higher interest rate. The thirty year bond,
however, will continue to pay only 6 percent for the rest of its thirty
year life. More about bond pricing and relationships to interest rates
in a future chapter. |
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Systematic versus Unsystematic Risk
Modern investment analysis categorizes the traditional sources of
risk causing variability in returns into two general types: those that
are pervasive in nature, such as market risk or interest rate risk, and
those that are specific to a particular security issue, such as business
or financial risk. Therefore, we must consider these two categories of
total risk. The following discussion introduces these terms. Dividing
total risk into its two components, a general (market) component and a
specific (issuer) component, we have systematic risk and nonsystematic
risk, which are additive:
Systematic Risk An investor can
construct a diversified portfolio and eliminate part of the total risk,
the diversifiable or nonmarket part. What is left is the
nondiversifiable portion or the market risk. Variability in a security's
total returns that is directly associated with overall movements in the
general market or economy is called systematic
(market) risk.
Virtually all securities have some systematic risk, whether bonds or
stocks, because systematic risk directly encompasses interest rate,
market, and inflation risks. The investor cannot escape this part of the
risk because no matter how well he or she diversifies, the risk of the
overall market cannot be avoided. If the stock market declines sharply,
most stocks will be adversely affected; if it rises strongly, as in the
last few months of 1982, most stocks will appreciate in value. These
movements occur regardless of what any single investor does. Clearly,
market risk is critical to all investors.
Nonsystematic Risk The
variability in a security's total returns not related to overall market
variability is called the nonsystematic (nonmarket)
risk. This risk is unique to a particular security and is
associated with such factors as business and financial risk as well as
liquidity risk. Although all securities tend to have some nonsystematic
risk, it is generally connected with common stocks.
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Market Risk
The variability in a security’s returns resulting from fluctuations
in the aggregate market is known as market risk. All securities are
exposed to market risk including recessions, wars, structural changes in
the economy, tax law changes, even changes in consumer preferences.
Market risk is sometimes used synonymously with systematic risk.
Interest Rate Risk
The variability in a security’s return resulting from changes in the
level of interest rates is referred to as interest rate risk. Such
changes generally affect securities inversely; that is, other things
being equal, security prices move inversely to interest rates. The
reason for this movement is tied up with the valuation of securities.
Interest rate risk affects bonds more directly than common stocks and is
a major risk faced by all bondholders. As interest rates change, bond
prices change in the opposite direction.
Purchasing Power Risk
A factor affecting all securities is purchasing power risk also known
as inflation risk. This is the chance that the purchasing power of
invested dollars will decline. With uncertain inflation, the real
(inflation-adjusted) return involves risk even if the nominal return is
safe (e.g., a Treasury bond). This risk is related to interest rate
risk, since interest rates generally rise as inflation increases,
because lenders demand additional inflation premiums to compensate for
the loss of purchasing power.
Regulation Risk
Some investments can be relatively attractive to other investments
because of certain regulations or tax laws that give them an advantage
of some kind. Municipal bonds, for example pay interest that is exempt
from local, state and federal taxation. As a result of that special tax
exemption, municipals can price bonds to yield a lower interest rate
since the net after-tax yield may still make them attractive to
investors. The risk of a regulatory change that could adversely affect
the stature of an investment is a real danger. In 1987, tax law changes
dramatically lessened the attractiveness of many existing limited
partnerships that relied upon special tax considerations as part of
their total return. Prices for many limited partnerships tumbled when
investors were left with different securities, in effect, than what they
originally bargained for. To make matters worse, there was not an
extensive secondary market for these illiquid securities and many
investors found themselves unable to sell those securities at anything
but "firesale" prices if at all.
Business Risk
The risk of doing business in a particular industry or environment is
called business risk. For example, as one of the largest steel
producers, U.S. Steel faces unique problems. Similarly, General Motors
faces unique problems as a result of such developments as the global oil
situation and Japanese imports.
Reinvestment Risk
It is important to understand that YTM is a promised yield,
because investors earn the indicated yield only if the bond is held to
maturity and the coupons are reinvested at the calculated YTM (yield to
maturity).
Obviously, no trading can be done for a particular bond if the YTM is to
be earned. The investor simply buys and holds. What is not so obvious to
many investors, however, is the reinvestment implications of the YTM
measure. Because of the importance of the reinvestment rate, we consider
it in more detail by analyzing the reinvestment risk.
Reinvestment Risk The YTM
calculation assumes that the investor reinvests all coupons received
from a bond at a rate equal to the computed YTM on that bond, thereby
earning interest on interest over the life of the bond at the computed
YTM rate. In effect, this calculation assumes that the reinvestment rate
is the yield to maturity.
If the investor spends the coupons, or reinvests them at a rate
different from the assumed reinvestment rate of 10 percent, the realized
yield that will actually be earned at the termination of the investment
in the bond will differ from the promised YTM. And, in fact, coupons
almost always will be reinvested at rates higher or lower than the
computed YTM, resulting in a realized yield that differs from the
promised yield. This gives rise to
reinvestment rate risk.
This interest-on-interest concept significantly affects the potential
total dollar return. The exact impact is a function of coupon and time
to maturity, with reinvestment becoming more important as either coupon
or time to maturity, or both, rises. Specifically:
Holding everything else constant, the longer the maturity of a bond,
the greater the reinvestment risk.
Holding everything else constant, the higher the coupon rate, the
greater the dependence of the total dollar return from the bond on the
reinvestment of the coupon payments.
Let’s look at realized yields under different assumed reinvestment
rates for a 10 percent noncallable 20-year bond purchased at face value.
If the reinvestment rate exactly equals the YTM of 10 percent, the
investor would realize a 10 percent compound return when the bond is
held to maturity, with $4,040 of the total dollar return from the bond
attributable to interest on interest. At a 12 percent reinvestment rate,
the investor would realize a 11.14 percent compound return, with almost
75 percent of the total return coming from interest on interest ($5,738/
$7,738). With no reinvestment of coupons (spending them as received),
the investor would achieve only a 5.57 percent return. In all cases, the
bond is held to maturity.
Clearly, the reinvestment portion of the YTM concept is critical. In
fact, for long- term bonds the interest-on-interest component of the
total realized yield may account for more than three-fourths of the
bond's total dollar return.
International Risk
International Risk can include both Country risk and Exchange Rate
risk.
Exchange Rate Risk All investors
who invest internationally in today's increasingly global investment
arena face the prospect of uncertainty in the returns after they convert
the foreign gains back to their own currency. Unlike the past when most
U.S. investors ignored international investing alternatives, investors
today must recognize and understand exchange
rate risk, which can be defined as the variability in returns
on securities caused by currency fluctuations. Exchange rate risk is
sometimes called currency risk.
For example, a U.S. investor who buys a German stock denominated in
marks must ultimately convert the returns from this stock back to
dollars. If the exchange rate has moved against the investor, losses
from these exchange rate movements can partially or totally negate the
original return earned.
Obviously, U.S. investors who invest only in U.S. stocks on U.S.
markets do not face this risk, but in today's global environment where
investors increasingly consider alternatives from other countries, this
factor has become important. Currency risk affects international mutual
funds, global mutual funds, closed-end single country funds, American
Depository Receipts, foreign stocks, and foreign bonds.
Country Risk Country risk, also
referred to as political risk, is an important risk for investors today.
With more investors investing internationally, both directly and
indirectly, the political, and therefore economic, stability and
viability of a country's economy need to be considered. The United
States has the lowest country risk, and other countries can be judged on
a relative basis using the United States as a benchmark. Examples of
countries that needed careful monitoring in the 1990s because of country
risk included the former Soviet Union and Yugoslavia, China, Hong Kong,
and South Africa.
Liquidity Risk
Liquidity risk is the risk associated with the particular secondary
market in which a security trades. An investment that can be bought or
sold quickly and without significant price concession is considered
liquid. The more uncertainty about the time element and the price
concession, the greater the liquidity risk. A Treasury bill has little
or no liquidity risk, whereas a small OTC stock may have substantial
liquidity risk.
Measurement of Risk
Volatility
Of all the ways to describe risk, the simplest and possibly most
accurate is “ the uncertainty of a future outcome”. The anticipated
return for some future period is known as the
expected return. The actual return over some past period is
known as the realized return. The
simple fact that dominates investing is that the realized return on an
asset with any risk attached to it may be different from what was
expected. Volatility may be described as the range of movement (or price
fluctuation) from the expected level of return. The more a stock, for
example, goes up and down in price, the more volatile that stock is.
Because wide price swings create more uncertainty of an eventual
outcome, increased volatility can be equated with increased risk. Being
able to measure and determine the past volatility of a security is
important in that it provides some insight into the riskiness of that
security as an investment.
Standard Deviation
Investors and analysts should be at least somewhat familiar with the
study of probability distributions. Since the return an investor will
earn from investing is not known, it must be estimated. An investor may
expect the TR (total return) on a particular security to be 10 percent
for the coming year, but in truth this is only a "point estimate."
Probability Distributions To deal
with the uncertainty of returns, investors need to think explicitly
about a security's distribution of probable TRs. In other words,
investors need to keep in mind that, although they may expect a security
to return 10 percent, for example, this is only a one-point estimate of
the entire range of possibilities. Given that investors must deal with
the uncertain future, a number of possible returns can, and will, occur.
In the case of a Treasury bond paying a fixed rate of interest, the
interest payment will be made with, 100 percent certainty barring a
financial collapse of the economy. The probability of occurrence is 1.0,
because no other outcome is possible.
With the possibility of two or more outcomes, which is the norm for
common stocks, each possible likely outcome must be considered and a
probability of its occurrence assessed. The result of considering these
outcomes and their probabilities together is a probability distribution
consisting of the specification of the likely returns that may occur and
the probabilities associated with these likely returns.
Probabilities represent the likelihood of various outcomes and are
typically expressed as a decimal. (Sometimes fractions are used.) The
sum of the probabilities of all possible outcomes must be 1.0, because
they must completely describe all the (perceived) likely occurrences.
How are these probabilities and associated outcomes obtained? In the
final analysis, investing for some future period involves uncertainty,
and therefore subjective estimates. Although past occurrences
(frequencies) may be relied on heavily to estimate the probabilities,
the past must be modified for any changes expected in the future.
Probability distributions can be either discrete or continuous. With
a discrete probability distribution, a probability is assigned to each
possible outcome. With a continuous probability distribution an infinite
number of possible outcomes exist. The most familiar continuous
distribution is the normal distribution depicted by the well-known
bell-shaped curve often used in statistics. It is a two-parameter
distribution in that the mean and the variance fully describe it.
To describe the single most likely outcome from a particular
probability distribution, it is necessary to calculate its expected
value. The expected value is the average of all possible return
outcomes, where each outcome is weighted by its respective probability
of occurrence. For investors, this can be described as the expected
return.
We have mentioned that it’s important for investors to be able to
quantify and measure risk. To calculate the total risk associated with
the expected return, the variance or standard
deviation is used. This is a measure of the spread or
dispersion in the probability distribution; that is, a measurement of
the dispersion of a random variable around its mean. Without going into
further details, just be aware that the larger this dispersion, the
larger the variance or standard deviation. Since variance, volatility
and risk can in this context be used synonymously, remember that the
larger the standard deviation, the more uncertain the outcome.
Calculating a standard deviation using probability distributions
involves making subjective estimates of the probabilities and the likely
returns. However, we cannot avoid such estimates because future returns
are uncertain. The prices of securities are based on investors'
expectations about the future. The relevant standard deviation in this
situation is the ex ante standard deviation and not the ex post based on
realized returns.
Although standard deviations based on realized returns are often used
as proxies for ex ante standard deviations, investors should be careful
to remember that the past cannot always be extrapolated into the future
without modifications. Ex post standard deviations may be convenient,
but they are subject to errors. One important point about the estimation
of standard deviation is the distinction between individual securities
and portfolios. Standard deviations for well- diversified portfolios are
reasonably steady across time, and therefore historical calculations may
be fairly reliable in projecting the future. Moving from well-
diversified portfolios to individual securities, however, makes
historical calculations much less reliable. Fortunately, the number one
rule of portfolio management is to diversify and hold a portfolio of
securities, and the standard deviations of well-diversified portfolios
may be more stable.
Something very important to remember about standard deviation is that
it is a measure of the total risk of
an asset or a portfolio, including therefore
both systematic and unsystematic risk. It captures the total
variability in the asset’s or portfolio’s return, whatever the sources
of that variability. In summary, the standard deviation of return
measures the total risk of one security or the total risk of a portfolio
of securities. The historical standard deviation can be calculated for
individual securities or portfolios of securities using total returns
for some specified period of time. This ex post value is useful in
evaluating the total risk for a particular historical period and in
estimating the total risk that is expected to prevail over some future
period.
The standard deviation, combined with the normal distribution, can
provide some useful information about the dispersion or variation in
returns. In a normal distribution, the probability that a particular
outcome will be above (or below) a specified value can be determined.
With one standard deviation on either side of the arithmetic mean of the
distribution, 68.3 percent of the outcomes will be encompassed; that is,
there is a 68.3 percent probability that the actual outcome will be
within one (plus or minus) standard deviation of the arithmetic mean.
The probabilities are 95 and 99 percent that the actual outcome will be
within two or three standard deviations, respectively, of the arithmetic
mean.
Beta is a measure of the
systematic risk of a security that cannot be avoided through
diversification. Beta is a relative measure of risk-the risk of an
individual stock relative to the market portfolio of all stocks. If the
security's returns move more (less) than the market's returns as the
latter changes, the security's returns have more (less) volatility
(fluctuations in price) than those of the market. It is important to
note that beta measures a security's volatility, or fluctuations in
price, relative to a benchmark, the market portfolio of all stocks.
Securities with different slopes have different sensitivities to the
returns of the market index. If the slope of this relationship for a
particular security is a 45-degree angle, the beta is I.O. This means
that for every one percent change in the market's return, on average
this security's returns change I percent. The market portfolio has a
beta of I.O. A security with a beta of 1.5, indicates that, on average,
security returns are 1.5 times as volatile as market returns, both up
and down. This would be considered an aggressive security because when
the overall market return rises or falls 10 percent, this security,
on average, would rise or fall 15
percent. Stocks having a beta of less than 1.0 would be considered more
conservative investments than the overall market.
Beta is useful for comparing the relative systematic risk of
different stocks and, in practice, is used by investors to judge a
stock’s riskiness. Stocks can be ranked by their betas. Because the
variance of the market is a constant across all securities for a
particular period, ranking stocks by beta is the same as ranking them by
their absolute systematic risk. Stocks with high betas are said to be
high-risk securities.
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