Types of investment risk and what you can do about risk
Risk is defined as the variability of returns from an investment.
Risk is the uncertainty related to the outcome of an investment, and
all investments are subject to risk of one type or another. The
greater the variability in the price, the greater is the level of risk.
Understanding the risks associated with different securities is
critical to building a strong portfolio. Risk is probably what deters
many investors from investing in stocks and prompts them to keep
their money in so-called safe bank accounts, CDs, and bonds.
Returns from these passive savings vehicles often have lagged the
rate of inflation. Although investors will not lose their capital, they
risk losses in earnings owing to inflation and taxes when they
merely hold cash and cash equivalents.
Business Risk
Business risk is the uncertainty that pertains to a company’s sales
and earnings, namely, that a company generates poor sales and
earnings for a period of time. By their nature, some companies are
riskier than others, and the riskier companies see greater fluctuations
in their sales and earnings. If a company’s sales and earnings
decline significantly, its stocks experience downward pressure.
Deterioration in sales and earnings, at worst, could move the company
into bankruptcy, which would make its securities (stocks and
bonds) worthless. A company with stable sales does not have this
problem of not being able to cover its regular expenses.
Investors’ expectations of a company’s earnings affect the
prices of its stocks. Shareholders who anticipate a decline in earnings
will sell their shares, which can cause a decline in the stock’s
price. Similarly, if investors anticipate an increase in earnings, they
are willing to pay higher prices for the stock.
Common stocks of auto, home building, construction, and
durable goods companies are referred to as cyclical stocks, and their
earnings and stock prices move directly up and down with the
expansion and contraction of the economy. Business risk for a cyclical
company increases when changes in the economy result in
reduced consumer or business spending for that company’s products.
This occurred in 2001 and 2002 when the telecommunications
equipment sector (companies such as Lucent, Nortel Networks,
and Ciena) experienced a downturn owing to an economic recession,
which caused the telecom companies (AT&T, Sprint, and
WorldCom) to reduce their spending on new equipment.
By investing in the common stocks of companies with stable
earnings rather than those of cyclical companies, you can reduce
business risk. Stable stock is the stock of a company whose earnings
are not influenced by changes in the activity of the economy. Some
examples are electric utility and consumer goods companies.
Financial Risk
Financial risk is the inability of a company to meet its financial
obligations, and the extent of a company’s financial risk is measured
by the amount of debt the company holds in relation to its
equity. A company with a high proportion of debt relative to its
assets has an increased likelihood that at some point in time it may
be unable to meet its principal and interest obligations. The greater
the debt-to-equity ratio, the higher is the financial risk because the
company will need to earn at least enough to pay back its fixedinterest
and principal payments. When a company carries a high
ratio of debt to equity, the company becomes a default risk (credit
risk). In addition to financial risk, business risk also can increase
default risk.
Companies that have little or no debt have little or no financial
risk. Looking at a company’s balance sheet reveals the amount
of debt relative to total assets and equity. At worst, financial risk,
like business risk, can lead a company to bankruptcy, making the
securities worthless. To reduce financial risk, invest in the securities
of companies with low debt-to-equity or low debt-to-totalasset
ratios. Table 4–1 lists the steps to determine the financial risk
for a company using the Internet. Figure 4–1 shows the categories
of total risk, which can be broken down into unsystematic and
systematic risk.
Table 4-1
How to Determine the Financial Risk of a Company Using
the Internet to Obtain the Information
You can determine the financial risk of companies that interest you by reviewing
their financial statements using the Internet.
1. Go to www.yahoo.com and click on “Finance.”
2. In the Enter Symbol(s) box, type the ticker symbols of the company or companies
that you want to research. If you want to know the financial risk of General
Electric Company, Intel Corporation, and Applied Materials, Inc., type “GE, INTC,
AMAT.” Make sure to separate each symbol with a comma. If you do not know
the symbol for a company, click “Symbol Lookup.”
3. Click the “Summary” view.
4. Click “Profile” for information on that company.
5. In the left column, click “Income Statement” in the Financials section. A screen
with an income statement appears. Look for “Earnings before interest and taxes”
(operating income) and “Interest expense” for the year (or quarter). Determine
the company’s coverage of its interest expense as follows:
Coverage ratio = earnings before interest and taxes/interest expense
Low coverage indicates that a sales decrease or an operating expense increase
may result in the company being unable to meet its interest payments.
6. Go to the left of the screen and click on “Balance Sheet.” Scroll down to
“Liabilities,” and add the total current and long-term liabilities. Look for the “Total
Assets,” and determine the debt ratio for the year or quarter as follows:
Debt ratio = total current and long-term liabilities/total assets
A large debt ratio with low coverage indicates high financial risk.
7. Evaluate the financial risk for each of the companies that you researched.
Figure 4-1 Breakdown of Total Risk
Unsystematic risk is the risk specific to a company or industry.
This risk pertains to a company’s business, its operations, and its
finances. Operating risk refers to contingent risks such as the death
of a CEO, a labor strike, or litigation. Unsystematic risk is also
known as diversifiable risk.
Systematic risk is caused by factors that affect all securities.
Systematic risk includes risks external to the company such as market
risk, event risk, interest-rate risk, exchange-rate risk, liquidity
risk, and purchasing-power risk. You cannot reduce market risk
through diversification.
Alleviating Business and Financial Risk
You can lessen your exposure to business and financial risk in your
portfolio of investments through diversification, which refers to the
purchase of different investment assets whose returns are unrelated.
By building a diversified portfolio, you reduce the variability in
returns (risk).
For example, if you invested your savings of $1 million in
the common stock of Intel Corporation on July 15, 2005, at $28.30
per share, a year later your loss would have been 37 percent of your
investment. Intel stock fell to $17.88 per share. Intel’s stock performance
was dismal when compared with the market for the same
period, July 15, 2005 to July 14, 2006. The Dow Jones Industrial
Average (DJIA) increased by 1 percent, the Standard & Poor’s
(S&P) 500 Index increased by 1 percent, and the Nasdaq Composite
Index was down by 6 percent for the same one-year period.
Table 4–2 shows the loss in a portfolio with an investment in Intel
Corporation’s stock.
Suppose that instead of investing the entire $1 million in Intel
stock for the one-year period, you decided to divide the money
equally into 10 stocks, as shown in Table 4–3. At the end of the same
one-year period, your diversified portfolio would have increased by
8.6 percent as opposed to the loss of 37 percent from investing the
entire amount in Intel. The gains in the portfolio came from aerospace,
beverage, oil, financial, and mining stocks (Boeing, Conoco-
Philips, Goldman Sachs, Citigroup, BHP Billiton, and PepsiCo).The
largest loss was from Intel in the technology sector of the economy.
The importance of diversification can be looked at another
way. With a portfolio consisting of one stock, a 50 percent decline
in that stock results in a 50 percent decline in the total value. In a
portfolio of 10 stocks with equal amounts invested in each stock, a
decline of 50 percent in one stock’s value, results in a 5 percent
decline in the total value. Thus too few stocks in a portfolio means
that you have too much risk placed on each stock. Too many stocks
in a portfolio dilutes the potential upside appreciation in the total
value of the portfolio.
Table 4-2
Portfolio with Only One Stock
| Date Bought |
Security |
Share Price |
No. of Shares |
Symbol |
Cost |
Market Price (7/14/06) |
Loss |
| 7/15/05 |
Intel |
$28.30 |
35,335 |
INTC |
$1 million |
$631,802 |
($368,198) |
Table 4-3
Portfolio with 10 Stocks
Investing in a number of stocks from different sectors of the
economy rather than investing in one stock the risk of loss decreases.
The returns on stocks from different sectors of the economy
are not perfectly correlated, thereby reducing the variability in
the returns. For example, the two financial stocks in the portfolio,
Citigroup and Goldman Sachs, have returns that generally move
together, a high correlation. Stocks from different sectors of the
economy have returns that are not related; they have a low or
negative correlation. By increasing the number of stocks in your
portfolio to 30 or 40 that have low or negative correlations, you can
effectively eliminate all company-related risks. Thus, of the total
risk, you can reduce unsystematic risk (operating, business, and
financial risk) through diversification.
Market Risk
Market risk refers to the movement of security prices, which tend to
move together in reaction to external events that are unrelated to a
company’s fundamentals. Market risk is the risk that market pressures
will cause an investment to fluctuate in value. Although you
can diversify investments to virtually eliminate business, financial,
and operating risks, you cannot do the same with market risk.
Diversification does not provide a safety net when an external
event causes a landslide in the stock markets. For example, when
the stock market goes up, most stocks go up in price, including
those with less-than-spectacular sales, growth, and earnings.
Similarly, if a sell-off occurs in the stock market, stocks with betterthan-
average sales, growth, and earnings will be included in the
downslide.
External events that move stock prices are unpredictable.
Such an event could be a terrorist incident or news of a war, death
of a prominent leader of a foreign nation, changes in the inflation
rate, labor strikes, or floods in the Midwest. Investors have no
control over these volatile, short-term fluctuations in stock prices.
Over long periods of time, however, stock prices tend to appreciate
in relation to their intrinsic value (their growth and earnings).
In other words, a stock’s long-term returns are determined by a company’s
investment fundamentals. Market risk highlights the dangers
for investors who invest short-term money in the stock market. If
you need cash when the market has declined, you will need to sell
your stocks, which may produce a loss. For stock investments, you
should have a long time horizon so that you are not forced to sell in
down markets.
Reducing Market Risk
Investors cannot do much about the volatility of the markets with
a short time horizon because the risk of potential loss is high with
stocks and other real investment assets. Stocks are more volatile in
price than bonds. Table 4–4 shows the historic returns of different
financial securities over a 78-year period from 1927 through 2005.
With a holding period of 78 years, annual returns averaged 10.34
percent for stocks, 5.2 percent for Treasury bonds, and 3.9 percent
for Treasury bills. Stocks clearly outperformed bonds and Treasury
bills. However, stocks also have the greatest risk, as measured by
their standard deviations, and small-cap stocks have greater risk
than large-cap stocks. The table illustrates the variability of returns;
stocks can range from a gain of 30.64 (10.34 + 20.3) percent to a loss
of 9.96 (10.34 – 20.3) percent. The variability of returns for Treasury
bonds is considerably less (a range of 11.3 percent gain to a loss of
0.6 percent).
With a short time horizon, the potential risk of loss from
investing in stocks increases. Table 4–5 shows historic returns for
stocks, bonds, and Treasury bills during the five-year period
1999–2004 and the 10-year period 1995–2004. Large-cap stocks
earned negative returns, but small-cap stocks, long-term corporate
bonds, and Treasury bills produced positive returns over the fiveyear
period. The significance of this table is that it shows the
importance of having long time horizons of greater than five years
for stock investments. Large-cap stocks, which carry less risk than
small-cap stocks, saw a decline in the five-year holding period,
whereas when the holding period is increased to 10 years, both
large- and small-cap stocks outperform bonds. When inflation is
factored into returns, risk, as measured by the standard deviation,
is lower for stocks than bonds and Treasury bills with holding
periods of greater than 30 years (Siegel, 2002, p. 32).
Table 4-4
Historic Returns, 1927–2005
|
Return (Risk) (Standard Deviation) |
| S&P 500 stocks |
10.34% (20.3%) |
| Treasury bonds |
5.2% (5.8%) |
| Treasury bills |
3.9% (3.2%) |
| Inflation |
3.9% (4.4%) |
Table 4-5
Historic Returns during the 5- and 10-Year Periods
1999–2004 and 1995–2004
|
5-Year Returns |
10-Year Returns |
| Small-cap stocks |
14.3% |
16.4% |
| Large-cap stocks |
-2.3% |
12.1% |
| Long-term corporate bonds |
10.7% |
9.5% |
| Treasury bills |
2.7% |
3.9% |
| Inflation |
2.5% |
2.4% |
The risk of loss through market risk is reduced further with a
20-year holding period, which is not all that long when looked at
in terms of the average life expectancy, which is more than 80 years
in the United States. The long time horizon for retirement funds is
suitable for stock investments.
Another factor that improves overall returns over a long holding
period is the reinvestment of dividends and capital gains.
Using asset allocation to choose a balanced portfolio of different
investments also reduces the effects of market risk, as shown in
Table 4–6. A mix of half large-cap stocks and government bonds
would have returned less than stocks alone, but the risk of loss is
reduced. The lowest five-year return for this mix over the 74-year
period was -3.2 percent for bonds and stocks versus -12.5 percent
for large-cap stocks. Bond markets, stock markets, and money
markets do not always rise and fall in tandem. During a stock
market decline, the bond and real estate markets could be rising,
and this provides some form of balance for shorter-term objectives.
Table 4-6
Historic Returns from Asset Allocation, 1926–2000
|
Return |
Greatest 5-Year Return |
Minimum 5-Year Return |
| 100% large-cap stocks |
11% |
28.6% |
-12.5% |
| 50% bonds, 50% large-cap stocks |
8.7% |
18.5% |
-3.2% |
Interest-Rate Risk
Interest-rate risk is the rise or fall in interest rates that affects the
market value of investments. Interest-rate risk refers to changes in
market rates of interest, which affect all investments. Fixed-income
securities (bonds and preferred stocks) are affected most directly.
In periods of rising interest rates, market prices of fixed-income
securities decline to make them competitive with yields of new
issues that come to the market. This decline in price causes a loss of
principal for fixed-income security holders. Similarly, in periods of
declining interest rates, prices of fixed-income securities increase,
resulting in capital appreciation. Rising and declining interest rates
have the same effect on real estate prices.
Changes in interest rates have a lesser effect on common
stocks than on fixed-income securities. High interest rates tend to
depress stock prices, and low interest rates tend to go hand in hand
with bull markets. High interest rates prompt many investors to
sell their stocks and move into the bond markets to take advantage
of the higher coupon rates of bonds. When interest rates come
down, investors move from bond and money market securities to
stocks.
Purchasing-Power (Inflation) Risk
Purchasing-power risk is the risk that changes in consumer prices
will erode the future purchasing power of returns from investments.
If prices in the economy rise (inflation), your future dollars
will purchase fewer goods and services than they do today. This is
called purchasing-power risk, and it has the greatest effect on investments
with fixed returns (bonds, savings accounts, and CDs) and
no returns (non-interest-bearing checking accounts and the hoard
under the mattress).
Assets with values that move with general price levels, such as
common stocks, real estate, and commodities, perform better during
periods of slight to moderate inflation. To protect against purchasing-
power risk, choose investments with anticipated returns
that are higher than the anticipated rate of inflation.
Of all the financial assets, common stocks have fared the best
during periods of low to moderate inflation. During periods of
high inflation, all financial assets, including common stocks, do
poorly. However, common stocks perform less poorly than bonds
and money market securities under these circumstances.
Event Risk
Event risk is broadly defined as the possibility of the occurrence of
an event specific to a company that could affect that company’s
bond and stock prices. For instance, Taiwan Semiconductor’s stock
dropped after an earthquake in Taiwan because investors feared
that the firm’s production facility had been damaged. Because
external events are difficult to predict, investors can do little to prevent
this type of risk. They can, however, estimate the effect that an
event would have.
Exchange-Rate Risk
Exchange-rate risk is the risk that the exchange rate of a currency
could cause an investment to lose value. An increase in the value of
the dollar against a foreign currency could decimate any returns
and result in a loss of capital when the foreign securities are sold.
This is called exchange-rate risk. For example, a 10 percent rise in
the price of the dollar to the British pound negates a 10 percent
increase in the price of British stocks. A declining dollar hurts not
only U.S. bond and stock markets but also the U.S. economy
because imported goods become more expensive, which is inflationary.
To temper potential increases in inflation, the Federal
Reserve does not hesitate to raise interest rates. This has a negative
effect on both the bond and stock markets. Bond prices decline
when interest rates rise, and investors sell their stocks when they
can get higher returns by moving into bonds.
Liquidity Risk
Liquidity risk is the risk of not being able to convert an investment
into cash quickly without the loss of a significant amount of
the invested principal. Certain securities are more liquid than
others; the greater the liquidity, the easier it is to buy and sell the
investment without taking a price concession. When investing
in a particular security, you should consider the following two
factors:
* The length of time you will need to hold the investment
before selling it
* The relative certainty of the selling price.
If you plan to use the funds in a short period of time, invest in
securities that are high in liquidity (savings accounts, Treasury
bills, money market mutual funds). A Treasury bill can be sold
quickly with only a slight concession in selling price, whereas a
20-year-to-maturity junk bond not only may take time to sell but
also may sell at a significant price concession.
Common stocks of actively traded companies on the stock
exchanges are marketable because they will sell quickly. They also
may be liquid if the selling price is close to the original purchase
price. However, inactively traded common stocks on the stock
exchanges and on the over-the-counter markets may be marketable
but not liquid because the spreads between the bid and ask prices
may be wide, and the sale price may be significantly less than the
purchase price. This could be a problem when you need to sell
inactively traded common stocks unexpectedly, and there are no
buyers for the stocks. You would have to sell the stocks at a lower
price to entice a buyer.
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