"No-risk investments" are a myth. There is no living
without risk; risk is a part of life. The more familiar we are
with the risks involved in an undertaking, the more precautions we
can take. The more we know about risks to our personal
property and assets, the more realistic we are in our goals and the
greater our chances of success in achieving them.
The real dangers are from unknown risks. Once we know the
risks, we can turn them into opportunities. At the very least, we
can develop recipes for minimizing them, and in the worst case, we
can limit the damage if we are hit and thereby avoid a total
investment disaster. This last certainly makes it worth learning
about risk.
Every investor should know the various types of risk
associated with investing in financial instruments. Formulating an
investment strategy which focuses only on returns ignores the fact
that certain risks are inextricably tied to an asset's performance.
Here are a number of the risks to which financial assets are
exposed.
1. Price Risk
Since asset prices reflect all the different risk factors
affecting supply and demand for an asset, the most generalized risk
faced by an investor is price risk. This risk is also related to
the volatility of an asset's price, i.e., how widely it swings up
and down. But since an upward movement is generally a welcome
occurrence, the concern in price risk is for a decline in the price
of an asset or in the entire portfolio's market value -- the
downside risk.
For common stocks, the primary source of price risk is in the
general fluctuations of the stock market itself. For bonds, the
risk is of a rise in interest rates which leads to a fall in bond
prices. The longer the maturity of the bond, the more its price
will change in response to a change in interest rates.
Price risk is the primary threat in the short-run for
investors. If you are not forced to sell, there is the
likelihood of prices recovering given enough time. A buy-and-hold
strategy is thus called for. Longer holding periods will moderate
the impact of volatile prices.
2. Default Risk
This is the risk that an issuer of a security may be unable to
meet the terms of the issue. Also referred to as credit risk, this
may mean that the issuer cannot pay interest in a timely manner or
cannot pay the principal at the end of the agreed upon period.
Default risk may also arise as a result of business risk. A
deterioration in a company's business prospects will adversely
affect the value of its outstanding stock and bond issues.
Default risk can be reduced by diversifying your investments
within an asset class. Your stock holdings should, for example, be
distributed in stocks among different industries.
3. Liquidity Risk
A liquidity risk exists when there is a chance that you will
have to sell an investment below its "true value" or can find no
ready buyer at that value. This is also called marketability risk.
If you have to take a loss in order to sell immediately as opposed
to waiting until an appropriate bid comes along, then the
investment is illiquid. Similarly, an investment is illiquid if
significant time and expense are required to find a suitable buyer.
Liquid assets are then those assets that can be sold quickly and at
a low cost.
Small company stocks as well as emerging-market stocks carry
a high degree of liquidity risk because of the low volume of stocks
traded in these markets.
The way to reduce the impact of liquidity risk is to invest in
assets with varying time frames. Then your cash flow will not be
significantly affected by hard-to-dispose of assets. Or you might
choose to invest in liquid vehicles for these assets: buy a real
estate investment trust (REIT) rather than a piece of real estate.
4. Market Risk
Any stocks or mutual funds you own will invariably suffer
losses if the stock market takes a plunge. And so will any bonds
you own if the bond market collapses. The risk that the fortunes
of the general market for an asset will adversely affect that
particular asset is market risk. Business cycles and market trends
-- including market psychology -- are the primary factors affecting
the risk of investing in a market. For example, at the start of an
economic boom when inflation and interest rates are low, bond
markets will likely not do as well as stocks. Or when U.S. stocks
are in a cyclical decline, foreign stocks may be heading up in
tandem with business cycles in the respective countries. Political
conditions can also affect the market's behavior. The run up to
elections or times of political crisis bring increased uncertainty
and therefore risk.
Diversifying into different asset categories and different
countries is key to reducing market risk. Additionally, a more
active approach relies on assessing the right place to be at the
right time and allocating a larger proportion of your assets (over-
weighting) to those markets.
5. Reinvestment Risk
This is the risk that comes from the possibility that an
investment will have to be reinvested at a lower interest rate or
at a higher price. While an increase in interest rates results in
a fall in bond prices, a decline in rates presents a
reinvestment risk for investors. Many bonds contain a provision
which allows issuers to redeem or call in all or part of the issue
before the maturity date.
Lower interest rates usually give issuers an incentive to call
in debt in order to be able to refinance at the lower rates. But
this forces investors to reinvest the cash proceeds at lower rates
as well. For a portfolio of stocks, a future increase in stock
prices poses the risk of having to reinvest profits or dividends at
a higher price.
A regular review of your portfolio will serve to moderate
reinvestment risk. What has changed from the time you made the
investment? Take the opportunity to adjust your investment
strategy and rebalance your portfolio.
6. Inflation Risk
A risk inherent in all assets is inflation risk. Take an
investor holding a one-year bond with a maturity value of $5,000
and an interest rate of 6%. At the end of the year, the cash
proceeds will amount to $5,300. If inflation over that year is 4%
then your real return (adjusted for inflation) is substantially
less than 6%. In this case it is $5,300 divided by 1.04 or $5.096.
Inflation reduces your returns because the cash flow from your
investments will buy fewer goods than before. Inflation risk or
purchasing power risk is the risk that inflation will result in a
negative real return.
Over periods of twenty years or more, studies have shown that
stocks outpace inflation far more than bonds or Treasury bills.
But in times of high inflation, gold and other hard assets are the
best hedge. And since inflation affects a currency's strength vis-
a-vis other currencies, investing in low-inflation countries is one
way to reduce purchasing power risk.
7. Exchange Rate Risk
The value of an asset denominated in a foreign currency will
fluctuate in its conversion to a base currency. In particular, the
value of an asset denominated in an appreciating currency rises and
that in a depreciating currency falls. If the Swiss franc
appreciates, a U.S. investor who holds a Swiss security will have
a gain. If an investor receives income from a Japanese yen bond
and the yen appreciates, the investor will receive more dollars.
The risk for an investor amounts to the possibility that the U.S.
dollar will have risen in relation to a foreign currency by the
time payments are to be received, resulting in dollar losses.
A number of factors give rise to exchange rate or currency
risk. These are related to supply and demand conditions for
foreign currencies relative to a base currency. A dollar-based
investor, for example, should consider such factors as inflation
rates, interest rates, savings rates, fiscal balances, the
current account balance (the balance of imports and exports of
goods, services and other transfers), and economic growth in the
respective foreign economy relative to the United States.
Currency markets have also increasingly been influenced by the
hedging practices of large institutional investors and
investment fund managers. In trying to anticipate exchange rate
movements, large amounts of currencies are bought and sold, with
significant short-term consequences for exchange rates. Central
bank intervention to support a currency, particularly when
coordinated among the central banks of the world's major
economies, is also an important determinant of short-run exchange
rate fluctuations. In the long-run, however, economic
fundamentals such as inflation rates and deficits or surpluses in
the country's financial accounts are the most important
determinants of a currency's strength.
Mutual funds and large companies with substantial foreign
currency exposure often take measures to hedge the impact of
currency movements. So when you invest in these funds or
companies you are already hedged to some degree. In the long-run,
the best strategy to reduce currency risk is to diversify among
different countries, choosing in particular those countries with a
record of low inflation, high savings rates and healthy balances in
fiscal and trade accounts.
The bright side of risk
That's seven risks inherent in investing. They affect
financial assets in different ways. The so-called low-risk assets
(such as Treasury bills and money-market mutual funds) prevent
capital losses but have little potential for appreciation and -- in
the long run -- are most vulnerable to purchasing power risk. On
the other hand, so called high-risk aggressive growth stocks are
not good vehicles for ensuring the safety of your principal in the
short-term but are a good way to hedge against inflation in the
long run.
Depending on your time horizon you should allocate more or
less money in instruments that have long-term profit potential
(stocks) or assets that can secure your capital and income today
(cash and fixed-income assets).
But whatever you do, don't be daunted by the risks. An
investor should treat risk as an entrepreneur treats a new
business venture -- as an opportunity to exploit. The flip-side of
taking greater risks, as modern portfolio theory points out, is
greater financial reward. With time on your side and a
carefully thought-out global investment strategy, the risks
themselves can be tamed to maximize your long-term profits.
If financial assets were completely riskless, there would be
no need for modern portfolio theory. In addition, if gathering
information -- both historical and current -- on the universe of
riskless investments were quick and easy, investors could choose
the one investment with the highest return, the highest income,
whatever criteria they may have. The reality, however, is none of
these things.
Modern portfolio theory is thus an essential tool for
investors. It recognizes that assets have risks. With the help of
today's computer technology, it helps to organize information about
assets and calculate risks. Finally, it offers investors a way to
reduce this risk and so increase potential returns.
The way shown by theory is through portfolio diversification.
Diversifying among different countries, for example, has been
proven to enable investors to earn higher returns. Numerous
studies using the general framework of modern portfolio theory also
point to longer holding periods for investments as a way to profit
from high-return but highly volatile equities. A properly
structured portfolio will take all these elements into account.
Jurg M. Lattmann is a Swiss investment counsellor and expert in
Swiss annuities.
Copyright © 1996 by Jurg M. Lattmann.
Reprinted with permission from
Swiss Perspective.
More information on international investment can be found at
The Offshore Entrepreneur.
