All investors, whether in stocks or fixed-interest instruments, have to continually weigh the various risks associated with their investments. Money in a savings account assumes no risk factor, since the return is precisely what was originally expected. Further an investment (for example, common stock) moves away from expected return, greater the risk. In short, risk can be defined as uncertain return.
While there are dozens of financial variables at play, from the health of the President to the level of housing starts, from the price of the country's currency in the foreign exchange market to the central bank's discount rate, the major sources of risk can be reduced to three categories.
The 3 most important investing risks
1. Interest rate risk
Since interest rates determine the price of borrowed money, changes in interest rates have a vast impact on investments, particularly since so many investors borrow money, whether for investing or to finance other purchases.
Budget deficits require the central government to borrow massive sums. The auction of treasury paper to cover these deficits is perhaps the chief element in setting interest rates, but other factors such as the bank interest rates, plus fiscal and monetary moves, all have their effects.
Interest rate changes are first felt in the fixed-income - or debt instruments, and subsequently in the stock market. So far as fixed income instruments are concerned, their values (prices) fall when interest rates rise, and go up when interest rates fall.
There is a tipping point - in the US generally thought to be about 10 per cent in the case of long tenor bonds, or when the spread between stock yields and money market funds becomes excessive, say 7 or 8 per cent - where the stock market can no longer compete with higher yields offered by the fixed-interest market.
At that point, i.e. when prevailing interest rates become so high, money flows out of stocks and into bonds. The perception of higher inflation - and higher interest rates to compensate for it - suggests that stocks are definitely subject to interest rate risk.
2. Company risk
If interest rate risk is first felt in the bond market, company or business risk is first felt in stocks. The risk, simply put, is that the company whose shares you have bought may go belly-up. While a bond or debenture holder has some recourse to the company's assets in such a situation, the stockholder is left to the mercies of the exchange.
Individual companies are open to the vagaries of business cycles, government policies, product and technology changes, management skills, labor relations, commodity shortages, hostile takeovers and natural calamities.
No two companies are affected in the same way, so company risk is sometimes called firm-specific risk or unsystematic risk, since what befalls one company does not usually have any bearing on another Clearly, each company's vulnerability is somewhat different and in some ways contradictory. Thus, if you own shares of a number of companies in your, the unsystematic risks will tend to cancel one another.
A diversified mutual fund of hundreds of companies all but eliminates unsystematic risk, but investors can achieve almost the same benefit by diversifying their holdings with 10 or 15 securities. Since diversification can eliminate most company risk, unsystematic risk is an unnecessary one to bear. In brief, prudent portfolio management requires canceling most company risk.
3. Market risk
Forces that affect the whole economic system and bear directly on the markets are generally inescapable. Like the spring rain, they fall equally on all, and no amount of portfolio diversification reduces vulnerability.
Some of the market risks - also called systematic risks - are political and legislative, such as the election of a new government and new tax codes; others are economic and financial, such as a recession or adjustments in currency value. Actions that affect all players are market risks, even though all participants may not be equally impacted. System-wide risk moves the stock market, as well as individual stocks, up and down.
The measure of this market volatility is termed beta, which equals unity, or 1. Specific securities can be measured against that general beta: They can be more volatile and have a beta of 1.5, or less volatile with a beta .5; the former is 50 per cent more volatile than the market, while the latter is half as volatile as the general market. The beta evaluation (based on a mathematical formula) is a measurement of market or systematic risk.
There are other types of risks or uncertainties, such as the future value of currency or purchasing power risk, but the three - interest rate, company and market - are the ones of greatest concern for investors.
How you can reduce risk
To some degree, investors can manage risk, or at least make it tolerable. Each type of risk can be countered by employing some market tactic. This will assist in fine-tuning the amount of exposure that comes with each risk situation.
For example, an investor can handle interest rate risk by appropriate timing to offset interest rate moves after careful study of the business cycle. An investor will try to lock in high yields if interest rates are about to fall (shortly before a recession commences) and, conversely, sell fixed income securities if interest rates are about to rise (when business starts to accelerate dramatically).
Market risk can be reduced, as noted earlier through proper diversification. Most investors make the mistake of buying only two or three securities. Economists have calculated that a portfolio comprising of shares of 12 to 15 of different companies will eliminate 91 per cent of all unsystematic or company risk.
To eliminate the remaining business risk, you would have to buy hundreds of more companies. Since that is obviously impractical, it is perhaps wise to buy mutual funds until such time as your resources are ample enough to permit you to buy a dozen different issues.
Finally, diversifying in time can reduce market risk. By constantly investing both during good times and bad, when the market is high and when the market is low, it is possible to average your way to lower prices or, conversely, increase your rate of return. Obviously, timing is a major concern to investors.
There are two possible solutions to the problem of timing: you can either develop the skills and talents necessary to trade the market, or side-step the problem altogether by using one of the formula investing strategies such as dollar averaging or systematic investment planning plans. The former will appeal to active traders, while the latter is attractive to long-term investors.
Excerpt from:
The Basics of Stocks
Author: Gerald Krefetz
Price Rs 190.
Gerald Krefetz is a principal of Krefetz Management and Research, he runs a private money management service for individuals in Manhattan, U.S.A. and has written more than twelve books.
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