Managing risk is a key element of successful investing. There a number of risks that all investors should be aware of.
Professional investors seek to minimise their risk, while optimising their return. The goal is to reduce risk, without affecting the return.
It’s important to note that it is impossible to completely remove risk when making investments. The stock market, in particular, yields higher returns than interest rates from a bank because the level of risk is increased.
For some people, investing in the stock market is unsuitable because they are not willing to take on so much risk.
Others reduce risk by investing in stocks and bonds. Government bonds are specifically considered to come with minimal risk so investors often invest in stocks and government bonds to minimise risk.
The more that someone investing in government bonds, rather than stocks, the more risk adverse they are. For example, if someone invests 90% of their money in government bonds and 10% in stocks, they should be considered very risk adverse.
For not taking risks, those investors will be rewarded less. If Government bonds return 2% and the stock market returns 10%, the investors would have a return of 2.8% (calculated as (90% x 2%) + (10% x 10%)).
As you can tell, there is an obvious relationship between risk and reward, the more risk that is taken on, the larger the return should be. The key is to invest as efficiently as possible to minimise risk as much as possible, while maintaining the same return.
At the most fundamental level, investors should be wary of inflation. If the inflation rate is too high, it can have a massive impact upon returns.
In finance when we talk about investment returns, we usually refer to the real rate of return – which is basically the returns made from an investment, minus the rate of inflation.
For example, if inflation is 2% and the return from your portfolio is 10%, the real rate of return would be 8%.
However, if inflation is 10% and your return is 10%, the real rate of return is 0%. Your money wouldn’t have increased in value.
If the returns of your investments are below the rate of inflation, it is time to seek out alternative investments.
In the UK, inflation is measured using the retail price index (RPI) and the consumer price index (CPI).
Interest rate risk can reduce stock market returns. This is because companies borrow money, just like individuals do, and when interest rates go up, their profits go down.
As profits go down, companies have less available capital to invest into their operation. As a consequence, stock market returns decline.
Equally, when interest rates go down, companies benefit from cheaper loans and then have more money to invest within themselves. Companies may also compare larger sums of money to take advantage of low interest rates.
Increased interest rates usually increases the price of bonds, which can make investing in bonds attractive. In general, the stock market and the bond market have an inverse relationship, when one goes up, the other goes down and vice versa.
The financial health of a company is a big risk for investors. If a company is not able to meet it’s liabilities, it can have a sizeable impact upon the stock price of a firm.
The ultimate consequence is that a company goes out of business, which can result in investors being left with nothing. This is simply because investors are owners of the firm and are therefore ranked at the bottom of the pile, below debtors.
In order to assess the financial health of a firm, there are a couple of ratios that can give some insight.
The first is called a current ratio, which is calculated by dividing the current assets of a company by the current liabilities. By doing this, an idea of how well a company can meet their short term liabilities will be given.
A current ratio above 1 is desirable as this means that a company can meet 100% of it’s liabilities. Legendary investment academic, Benjamin Graham, recommends looking for companies with a current ratio of 2.
Be careful though as a company that has a very high current ratio (of say 3) can indicate that they are not efficiently managing their money.
Another ratio for assessing credit risk is the cash ratio – which is similar to the current ratio just with cash (or cash equivalents).
It gives you an idea of whether a company has enough money in cash to cover their short term liabilities.
Like current ratios, if the cash ratio is 1, it means that a company has enough money in cash to meet it’s short term liabilities.
Systematic risk, also known as market risk, is risk that typically effects the whole market. Such risks are known as undiversifiable as it is not possible to diversify the risk away.
Diversification is the most well known way to reduce risk in general, something that won’t work when the risk impacts upon the whole market.
Market risks are typically driven by factors that have the potential to impact upon macroeconomics. For example, if governments decided to increase corporate tax rates, the whole stock market would likely decrease in value in response.
The only way to reduce market risk is to invest in multiple stock markets. Instead of simply investing in the FTSE100, investors could invest in the S&P 500, DAX 30 or Nikkei 225.
Related to market risk is event risk, which commonly refers to a single event that can shock a stock market.
9/11 is a classic example of event risk, whereby a terrorist attack in the United States had a detrimental effect upon global stock markets.
Other event risks could include pandemics, natural disasters or cyber attacks.
It’s not always possible to reduce risk when it comes to event risk as they can affect all stocks in all stock markets and can happen very suddenly. In some cases it is possible though.
For example, with the COVID-19 pandemic, investors were able to reduce event risk by buying positions in internet companies and logistics firms.
Currency risk is slightly more complex as companies can operating in different countries to vary degrees.
For example, Company A may operate 25% of their business in Turkey, exposing themselves to weakness to the Turkish Lira by 25% of their total income.
The impact upon Company A’s income depends upon what other countries it operates in and how correlated the currency of said company is with the Turkish Lira.
For simplicity, the more countries that a company operates in, the more reduced the currency risk is.
The most obvious distinction when it comes to currency risk is between domestic and international companies. Domestic companies (operating in a single country) are very vulnerable to currency movements, while international companies are more protected.
This concept is best illustrated by Brexit, whereby international companies thrived and domestic companies dwindled.
The reason for this is that domestic companies often rely on importing goods from other countries, where they don’t have a presence. When the pound devalued as a result of the Brexit vote, importing goods became more expensive for British firms that only operate domestically.
International firms, like BP, thrived on the other hand as they were able to convert their foreign currency into more pounds.
For this reason, it’s important to diversify currency exposure in a portfolio in order to avoid currency vulnerabilities.