Types of investment risk and what you can do about risk 

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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
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

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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