Risk Management Primer — A Legacy Review
In the investment community, risk is not necessarily considered negative, but rather a deviation from an expected outcome. Risk is also inseparable from return; in order to gain more profit from an investment, you generally need to assume more risk.
The term “risk-free investment” is a misnomer. All investments are risky — even the “safe” ones like certificates of deposit (CDs) and Treasury bonds (T-bonds). In the investment community, in fact, risk is not necessarily considered negative, but rather a deviation from an expected outcome. Risk is also inseparable from return; in order to gain more profit from an investment, you generally need to assume more risk. At the time of this writing, December 2020, the interest on CDs is at an all-time low, and T-bonds too have among the lowest interest rates of any investment product — less than 1%.
Does this mean that you shouldn’t participate in financial markets? Not at all. It means that you need to be a conscientious investor and practice financial risk management. Make it your business to know and understand investment risk and the potential risks of each type of financial asset and investment vehicle. And know your own risk tolerance based on your temperament, goals, and financial reality. Some say that if you can’t afford to lose it, then you shouldn’t invest it.
Types of Risk
When we speak of financial risk, we’re referring to the potential that you could lose money on an investment or business venture. We may divide risk broadly into two types, systematic risk (or market risk) and nonsystematic risk (or business risk). Systematic risk affects the entire economy. It’s the risk that financial markets could decline altogether, bringing down the value of all kinds of investments, regardless of their individual characteristics. Sources of systematic risk can include recessions, political unrest, a change in interest rates, natural disasters, and terrorist attacks. In contrast, nonsystematic risk has to do with a particular company, industry, or financial product. Although both types of risk are unpredictable, you may be able to anticipate some types of nonsystematic risks and mitigate them by diversifying, whereas you generally cannot mitigate systematic risks.
Systematic (Market) Risk
A good example of a systematic risk is the Great Recession of 2007-2009. If you were invested in the market during that economic event, then you well remember the disastrous descent that all securities suffered. The Great Recession had different effects on different asset classes. The riskier securities — those that were more highly leveraged, like collateralized mortgage obligations (CMOs) — were sold off in large quantities, while the simpler assets, like U.S. Treasury bonds (T-Bonds, or Treasuries) became more valuable.
Within market risk there are sub-categories, such as risks brought about by changes in interest rates, inflation, lack of liquidity, and risks brought about by changes in the exchange rate between two relevant currencies — all of which can have a negative impact on the value of securities.
Nonsystematic (Business) Risk
Nonsystematic risk can be inherent in a specific company, sector, or investment product, and it affects each entity differently. You may think of nonsystematic risk as something that’s integral to a company's day-to-day operations and success, which could potentially affect a firm’s value and solvency. Examples of nonsystematic risk include a firm not being able to continue producing a best-selling product because it can no longer find the main ingredient; a critical executive leaving and taking the entire department with them; or a competitor entering the marketplace that could potentially take away significant market share from a company in which you’ve invested — e.g., a McDonald’s opens up across the street from a mom-and-pop burger joint whose stock you just purchased.
Things You Can Do to Manage Your Investment Risk Management
Although you can never completely avoid investment risk, there are things you can do to try to manage it.
First, you need to understand your own relationship to financial risk management. How do you do this? Answer this question: Would you prefer a steady job with a company that pays very little, but you understand it because you’ve been there for the past five years; or a freelance job that pays a lot more, but is in an exciting new field that you know nothing about? If you chose the former, then you might have a low tolerance for risk, or be downright risk-averse. If you chose the latter, then perhaps you could tolerate a bit of risk to explore the potential upside of the unknown. If you’re still unsure, then trust your gut. Many people fall somewhere in the middle of having a low or high tolerance for investment risk. One is not better or worse than the other; it’s just a matter of knowing what makes you most comfortable. When you’re aware of your risk tolerance, you are better positioned to choose investments that align with your investment goals and work with your temperament.
Know Your Investment Vehicles
This is where it’s important to distinguish your stocks from your CMOs. Because some investment products are inherently riskier than others, your choice of products, along with the percentage they occupy in your portfolio, really does matter. U.S. government-issued T-bonds, for example, are widely thought to be one of the safest investments in the world. Some believe that these securities are even risk-free because they’re backed by the U.S. government's ability to tax its citizens. However, though not probable, it’s not impossible for the U.S. government to collapse altogether.
Bonds present a particular kind of nonsystematic risk. A bond issuer could default on its interest payments or on returning your principal when the bond matures (credit risk), or the company could exercise its call provision (call risk). And because bonds are directly affected by changes in interest rates, they’re also subject to interest-rate risk. The good news about nonsystematic risk is that because you can foresee it, you can try to offset it with a well-diversified portfolio.
Diversify, Diversify, Diversify
Diversification is a well-known portfolio-management tool. Basically, it protects you against putting all your eggs in one basket. But you don’t need to be a professional money manager to balance your own portfolio. You can, for example, try for a better overall return by purchasing a high-yield bond index fund to help offset your safer, but low- interest-bearing, T-bonds and CDs. Index funds offer a kind of automatic diversification because they contain a quantity of assets instead of just one. Before you begin any investment journey, you should speak to a qualified professional who can help you assess your risk-tolerance and steer you toward the investment vehicles that are most appropriate for you.
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