Canadian Finance Blog

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Investment Risks Posted: 02 Oct 2010 02:00 AM PDT The following excerpt is from Winning The Loser’s Game, written by Charles D. Ellis and published by McGraw-Hill. Risk is such a simple little word that it is amazing how many different meanings are given to it by different users. Risk is different from uncertainty. Risk describes the expected payoffs when their probabilities of occurrence are known. Actuarial mortality tables are a familiar example. The actuary does not know what will happen in 14 years to Mr. Frank Smith but does know quite precisely what to expect for a group of 100 million people as a group—in each and every year. "Riskiness" in investing, by contrast, is akin to uncer­tainty, and that's what the academics mean when they discuss beta (relative volatility) and market risk. Too bad they don't use the exact terms. Risk is not having the money you need when you need it. Risk is both in the markets and in the individual investor. Some of us can live comfortably with near-term market volatilities—or, at least, resist the primal urge to take action—knowing that over the long run, more market volatility usually comes with higher average returns. Active investors typically think of risk in four different ways. One is "price risk": You can lose money by buying stock at too high a price. If you think a stock might be high, you know you are taking price risk. The second type of risk is "interest rate risk": If interest rates go up more than was previously expected and are already discounted in the market, your stocks will go down. You'll find out that you were taking interest-rate risk. The third type of risk is "business risk." The company may blunder, and earnings may not materialize. If this occurs, the stock will drop. Again, you were taking business risk. The fourth way is the most extreme, "failure risk." The company may fail completely. That's what happened with Penn Central, Enron, WorldCom, and Polaroid. As the old pros will tell you, "Now that is risk!" And that's why we should all diversify. Real risk is simple: not enough cash when money is really needed—like running out of gas in the desert. The old pros wisely focus on the grave risk all investors—and 401(k) investors in particular—should focus on: running out of money, particularly too late in life to go back to work. Another way to look at risk has come from the extensive academic research done over the past half century. More and more investment managers and clients are using it because there's nothing as powerful as a theory that works. Here's the concept: Investors are exposed to three kinds of "investment risk." One kind of risk simply cannot be avoided, so investors are rewarded for taking it. Two other kinds of risk can be avoided or even eliminated, so investors are not rewarded for accepting these unnecessary and avoidable kinds of risk. The risk that cannot be avoided is the risk inherent in the overall market. This market risk pervades all investments. It can be increased by selecting volatile securities or by using leverage— borrowed money—and it can be decreased by selecting securities with low volatility or by keeping part of a portfolio in cash equivalents. But it cannot be avoided or eliminated. It is always there. Therefore, it must be managed. The two kinds of risk that can be avoided or eliminated are closely associated. One involves the risk linked to individual securities; the other involves the risk that is common to each type or group of securities. The first can be called "individual-stock risk," and the second can be called "stock-group risk." Few examples will clarify the meaning of stock-group risk. Growth stocks as a group will move up and down in price in part because of changes in investor confidence and willingness to look more or less distantly into the future for growth. (When investors are highly confident, they will look far into the future when evaluating growth stocks.) Interest-sensitive issues such as utility and bank stocks will all be affected by changes in expected interest rates. Stocks in the same industry—autos, retailers, computers, and so forth—will share market price behavior driven by changing expectations for their industry as a whole. The number of common causes that affect groups of stocks is great, and most stocks belong simultaneously to several different groups. To avoid unnecessary complexity and to avoid triviality, investors usually focus their thinking on only major forms of stock-group risk. The central fact about both stock-group risk and individual-stock risk is this: They do not need to be accepted by investors. They can be eliminated. Unlike the risk of the overall market, risk that comes from investing in particular market segments or specific issues can be diversified away—all the way to oblivion. Related Posts: Non-US Investment Principles Different From Common Investment Advice What Are The Risks Of Leveraged Investing? What Is A Price To Earnings Ratio (P/E Ratio)? Investment Risks originally appeared on Canadian Finance Blog on October 2, 2010.

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