Risk Considerations

In terms of investing, risk is basically the uncertainty that you will lose the money you invested or not make the return you required, and no investment is without risk. Risk is present in a variety of ways and entire professions have been created around identifying and mitigating risk. We’ll first look at the different components of risk, the general risks associated with specific asset classes and ways to mitigate these risks.

Components of Risk

There are number of risks and the easiest way would be to simply list them with a description. In general, the important risks to note are:

Non-systematic (business) risk

This refers to the risk a single, stand alone, investment carries specific to that investment. An example could be an accounting scandal faced by a company in which the company goes under and you lose your investment in that company.

Systematic (market) risk

This refers to the risk of the market as a whole. An example could be a civil war occurring in a country in which you have invested, this civil war would arguably cause the entire market (and all those invested in it, not just you) to suffer.

Credit risk

The risk that the issuer of an investment, usually for fixed income, does not make their obliged payments. Simply, you run the risk of not getting paid.

Liquidity risk

The risk that you are unable to sell (or buy) your investment when you want to. This results in being unable to turn an asset into money that can be used to buy things, or redeployed to invest in another attractive investment opportunity.

Interest rate risk

This risk is tricky to understand and has to do with fixed income investments. Essentially, it’s the risk that prevailing interest rates will change resulting in an adverse effect of your current investment. Or that you may lose out on being able to invest in an asset at a better interest rate because your money is tied up in the previous, lower interest rate, investment.

Inflation risk

Inflation is defined as the increase in the general price level of goods in the market. It is measured by recording the prices of a specific set of common goods from month to month and year to year.

For instance, if a bag of sugar costs R20 today and the following year it costs R20.80, it means the economy has experienced an inflation rate of 4%. So if you put R20 into an investment that returns 4% (inflation) you have maintained the buying power of your money since you can still buy exactly one bag of sugar. If the investment returns less than inflation you would have lost buying power.

A very important concept when investing is the difference between the nominal rate of return and the real rate of return. The nominal rate of return is calculated as the absolute return an investment makes. So if you invest R20 and after a year you have R22, you would have made a nominal return of 10%.

The real rate return is the difference between the nominal rate and inflation. Continuing with the example above, the real rate return will be 6% (10% – 4%). As long as the real return is positive, you will maintain your buying power.

Asset Class Risks

We will explore non-systematic and systematic risks in more detail below since every asset class faces these risks. Briefly though, the significant risks other than these two for each asset class and why is provided below:

Equity

Although most stock exchanges around the world are efficient, there are many instances where liquidity can be an issue when investing in shares. This is specifically so when the company is small and relatively unknown. Larger companies, such as the classic “blue chips” do not suffer from liquidity issues as much since there is usually a sufficient amount of people to buy or sell the share.

Inflation risk for the equity investor can occur directly and indirectly. It occurs directly when the investment return itself does not keep up with inflation and the investor’s buying power decreases. It occurs indirectly when a business finds itself in the tricky situation of buying inventory at higher prices to sell, yet keeps the selling price of its products the same. The higher inventory price combined with the same selling price reduces profits. However, this is usually temporary in nature and the selling price should increase eventually.

Fixed Income

There has been a marked decrease in bond liquidity post the global financial crisis and unless a bond is either great quality or “on the run”, i.e. the most recent issue in the market and widely available, it is not uncommon for investors to hold bonds for a number of years simply because no one will buy them.

As you can imagine, a major factor for investing in fixed income is the higher certainty of income payments. However, when the issuer does not make these payments for whatever reason, e.g. bankruptcy, it can have devastating consequences for the investor.

Interest rate risk is also primarily a concern for fixed income investments, and combined with lower liquidity in the market, it can result in unfavorable investment outcomes. For example, you may buy a bond that offers an interest rate (coupon payment) of 5%, only for new bonds to come out a year later offering 6%. The change of 5% to 6% is an example of interest rate risk.

You’re now in a position in which you may want to swap over to the 6% bond, but in order to do so you need to sell your current bond, only there is no one willing to buy the lower interest rate bond. An example of liquidity risk.

Inflation risk is also a big concern with fixed income since inflation can eat away at the buying power of the money invested. Should the payment rate fall below the inflation rate due to inflation rising, the real return of the fixed income investment decreases.

Alternative Investments

Liquidity risk is probably the most significant risk with alternative investments. Especially with regards to direct real-estate. Anybody who has ever bought or sold a house knows what a process it is and how long it can take to find a buyer or seller, not to mention the red tape that comes with the transaction.

This is also true for commodities in which you have the physical asset, such as holding bars of gold. Depending on how much gold you have, it may take significant effort to find a buyer who can buy and store it.

Credit risk is associated with indirect real-estate investment (through REITs) but probably not in the way you imagine. The risk occurs at the business level, i.e. can the tenants pay the rent to the REIT in which you have invested in?

If a significant amount of tenants default on their payments to the REIT, then the trickle down effect is receiving a lower (and worst case zero) dividend since the REIT literally has no money to distribute as a dividend.

Interest rate risk is also associated with REITs at the business level. For instance, a lot of the properties the REIT owns may have a bond portion that REIT needs to pay off. Should interest rates increase the result is higher bond payments made by the REIT, which may reduce the amount the size of the dividend because there is less available to distribute since more of it is going to towards covering the higher bond payments.

A major benefit of real-estate and commodity investment is that they generally do well in an environment of rising inflation. This is because the owners of real-estate generally increase the rent charged according to inflation, and commodities generally increase in value with inflation. In this way the prices, and corresponding return, help maintain the buying power of the money invested.

Mitigating Risks

Non-systematic (business) risk

The primary way to mitigate non-systematic risk is to have a diversified portfolio. I’m sure you’ve heard of the saying “don’t put all your eggs in one basket”. Well this is particularly true for investing. Diversifying across a number of investments significantly reduces the impact of one investment turning bad since the remaining investments can help pick up the slack.

Another method is to have limits as to how much a portfolio can invest into one single asset. This technique is simple in nature and along with diversification should be considered golden rules.

Lastly, prudent and thorough analysis should be done before putting money in any investment. The deeper the analysis the less chance you have of putting your money in an investment that could tank.

Systematic (market) risk

This is a very difficult risk to mitigate since it generally affects the entire market. However, diversification across industries or countries can help with localized systematic risk. If you have investments around the world and the South African market takes a dive, it will have a lessor effect than being invested in the South African market alone.

Investing into different asset classes also helps in the same way. If you have a 50%/50% split of equities and fixed income in your portfolio and the bond market takes a dive due to rising interest rates, your equity portion should hopefully help you out. More complicated methods do exist to mitigate this risk but are generally only used by institutional asset managers.

Credit risk

Due diligence is the best method of mitigating this risk. A thorough analysis into the credit-worthiness of the issuer needs to be done in order to understand the issuers capability of making their obliged income payments.

Fortunately credit ratings agencies such as Moodys, Fitch and Standard and Poor’s help with the analysis by providing credit ratings of various bonds issued by businesses and countries.

Liquidity risk

Sometimes it’s not possible to mitigate this risk since the asset you want to invest in exists in a market that is simply illiquid. Therefore you may need to rather manage the risk, such as having a detailed exit plan by identifying a buyer in advance, or sticking to investments and asset classes that exist in a highly liquid market.

A great way to mitigate the liquidity risk is by investing into an investment vehicle such as an ETF or unit trust. These vehicles are generally very liquid and there usually isn’t an issue with turning your investment to cash when you need to, within a reasonable amount of time.

The catch is that you normally do not have a choice as to which underlying assets within the vehicle are included, since the asset manager will choose which assets are in the unit trust portfolio and the ETF will track a predefined basket of assets.

Interest rate risk

This is a very tricky risk to mitigate for the amateur investor since the products available to offset this risk are generally reserved for institutional investors. Asset managers, as an example, may use various derivatives (a form of alternative investment) to buy “insurance” against adverse interest rate movements.

Unfortunately these products are not available to everybody, and those of us who cannot access them are left to our own wits. Unless you diligently follow market happenings and can accurately predict when and by how much interest rates will change, it’s best to either allow an asset manager to take care of it (through investing in a unit trust), or invest into assets which have less sensitivity to interest rate changes.

The latter approach may not be feasible though because it would mean potentially excluding the entire fixed income asset class which is not ideal. In general though interest rates remain relatively constant, and there is often sufficient commentary from those in charge of a country’s monetary policy to allow sufficient time for you to realign your investments before interest rates change significantly.

Inflation risk

Unlike interest rate risk where you can gauge (to a certain extent) which way interest rates will move and when, inflation is far more sneaky. There may be times in which a “shock” inflation result comes out that is much higher than anticipated.

This generally gives the market a fright and people often scramble to rebalance their investments in line with the new data. In most countries however, the people in charge of the monetary policy of the country will try their best to keep inflation as constant as possible.

This means that although there may at times be a “shock” result, as long as inflation is relatively constant over the long term (i.e. near the same level when you first took it into account) there isn’t too much to worry about.

The most effective way of mitigating the inflation risk though is to invest into assets that generally move with inflation, such as real-estate and commodities. Or invest into fixed income assets that derive their income payments from inflation.

The latter is one of the best ways to mitigate inflation risk and there are a few products out there that are available to amateur investors. These include inflation linked ETFs, inflation linked SA Retail Savings Bonds and unit trusts that have an inflation targeting mandate.

Next: Portfolio Construction Considerations

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