Risk is inherent in life. There is no escaping it no matter how much you may try. Risk is also inherent in investing and trading, and just like life, we can’t escape it. We can, however, take steps to reduce our exposure to it.
What is Risk?
The Oxford English Dictionary defines risk as “the possibility of something bad happening at some time in the future; a situation that could be dangerous or have a bad result”. Risk is something that we are all familiar with, it’s the reason we look left and right when crossing the road. But what does it mean in terms of investing or trading?
Investopedia defines financial risk as “the chance that an outcome or investments actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment”. An interesting takeaway from the above definition is that risk can be both positive and negative. An investment that returns double the expected return would be classed as a positive risk outcome, one that returned half the expected return would be classed as a negative risk outcome.
Risk is usually seen as a bad thing, both in life and investing. That’s not always the case. When we invest, we are trying to minimise our downside risk while maximising our upside risk. Investing and trading would be a much less lucrative business if positive risks didn’t exist.
Risk – Return
A core concept in the world of finance is the risk-return tradeoff. At its most basic it means that the more risk you are willing to take the more reward you will possibly gain. This should be taken into account while doing your research on an investment decision or trade. If you are investing in a stock that has the potential to lose 30% but the potential to gain 10% would you buy it?
Risk-reward is not an exact science. There is no way to know exactly how low or high a stock may go. You may be able to limit your risk if you are willing to close a position early at a pre-determined point. This is known as a stop-loss. A stop-loss isn’t really used when investing for the long term, by its nature you will ride out downturns so having a pre-determined exit point may not be beneficial.
In trading, however, a stop-loss is an integral part of your trading plan. Before entering a trade you should identify exactly how much you are willing to lose, usually expressed as a percentage of your overall account. The stop-loss should be placed at a point at which your rationale for entering the trade has been proven incorrect. Say for example you are trading a stock that is on an upward trajectory. You want to buy when the trade is confirmed at the new high (you may choose to buy on a pullback after the new high also). Once you buy, you want your stop loss located below a recent low point, if the price breaches the low point the price has made a lower low and the upward trend is no longer present. If the upward price trend has not continued you will be taken out of the trade automatically, reducing your loss to the original risked amount.
This is just a simplified example. In trading, a stop-loss will also let you calculate the correct position size to use and this will be covered in a later post.
Types of Risk
There are two main types of risk: systematic and unsystematic risk.
Systematic risks affect the entire market. These can be political risks, macroeconomic risks, interest rate risks and inflation risk to name a few. As these risks affect the entire market, it can be difficult to mitigate the risks. If there is a stock market crash, your portfolio will be impacted no matter how many different stocks you own. While it is difficult to mitigate systematic risks, it is not impossible. Having a wide range of assets can lessen the impact of a negative systematic event. An economic crash can decimate your stock portfolio but a safe haven asset like gold might be able to offer some protection.
Unsystematic risks affect specific businesses or industries. They can be anything from a change of company management to increased competition in a sector. As they are not market-wide risks, diversification can play a key role in mitigating unsystematic risks. The more industries and companies you are invested in the less of an impact an unsystematic risk will have on your overall portfolio.
As well as systematic and systematic risks, there are other elements of an investment decision that can affect the overall risk of the position.
- Capital at Risk: This is the easiest to understand and explain. The more money you put at risk the more the potential return you will receive. For example, if Investor A and Investor B both buy shares in Company X but Investor A buys 10 times more shares, his potential losses and gains are greater in monetary terms. Note, they may invest the same percentage of their assets respectively, but in monetary terms, the bigger investment has the potential for bigger rewards even though the percentage return may be the same.
- Leveraged Risk: In a leveraged instrument, your gains and losses are magnified by whatever the leverage amount. Naturally, they are riskier than unleveraged positions, but they can also provide a greater return.
- Time Risk: I wasn’t sure what to call this point, but time risk will do. Using Investor A and B as above, let’s assume they both invest the same amount in a basket of stocks. Investor A plans to hold the stocks for 25 years, while Investor B only plans to hold them for 5 years. Investor B has a riskier position due to his shorter investment horizon. It is much more difficult to recover from a market setback within 5 years than 25 years. Investor A can ride out the market fluctuations safe in the knowledge that over time his investment should generate good returns. This comes with a caveat, the market can fall at any time. A crash could happen during the 24th year of Investor A’s holding period, but the gains up to that point should outweigh the drop (the stock market historically returns roughly 8% per year).
- Foreign Exchange Risk: If you buy a stock in a currency other than your home currency, you will be exposed to foreign exchange risk. If the value of the stock rises and the value of your home currency rises you would not receive the full benefits of the stock appreciation. Let’s assume you are an EU investor investing in US shares. Over a period of time, the stock price does not change, a 0% return but the Euro gains strength against the dollar by 5%. When you convert your position back into Euro you have lost 5%.
How Do You Reduce Risk?
The easiest and most effective way to reduce investment risk is to diversify. Diversification will have its own blog post in the future, but for now, there are a few simple steps you can take.
- Invest in a variety of asset classes. Ensure you have exposure to stocks, bonds, real estate and commodities.
- Ensure you are diversified within each asset class. Your stock portfolio should include different companies, industries and countries. Your bond portfolio should contain long and short term bonds, corporate and government bonds.
By spreading out your assets you are in the best position to reduce your exposure to each individual asset.
When researching an asset, ensure you are looking at your overall risk profile before deciding to purchase. While the purchase of a blue-chip stock may diversify your stock holdings, it won’t offer much protection if you are fully invested in stocks. In this case, a bond may be a better choice. As with all aspects of investing and finance, it is important to do your research before deciding on an investment.
The Stoic Trader