Understanding Investment Risk
Risk is a part of any investment undertaking. The difference between getting blindsided by the realization of risk and cashing in on great returns is in properly considering risk when making decisions. It is imperative to fully appreciate the different types of risks involved in the variety of investment choices we consider.
The usual concerns about stock prices that are higher than the segment and bond yields that do not measure up are part of the risks players consider. There are certainly concerns when firms do not meet earnings projections and market volatility threats. Think “Enron” and the risk of executives cooking the books instantly pops into mind. Terrorism is not far from any market or investor’s consciousness in the world today either.
The question is what to look for to optimize your returns and still avoid risk. The answer hinges on the definition of risk. Investors consider the possibility of losing money as the highest risk and consider the investment’s volatility as a measure of risk. Investors toss that word “volatility” around like we all know what it means, but if you don’t know then it is time to find out. Volatility is really a statistical measurement of the susceptibility of the market or a security to gain or lose value. A highly volatile market or individual stock is one that has huge bounces in price in a short period of time. Investments that are very volatile are risky and conversely low volatility translates to low risk.
There are other measures of risk. One measure is to assess the probability that an investment will realize the projected returns. While certificates of deposit generally can be expected to provide the percent of return indicated at purchase, and are considered very low risk; stocks are risky investments because they can vary widely from projected returns. If you purchase a three year CD that yields 3.5% it is pretty much guaranteed to earn that 3.5% over the three year time period. The stock market may not be so kind. If you choose an investment, perhaps through a mutual fund that reflects the Standard and Poor’s 500-stock index you could expect the fund to return 10% per year. A savvy investor would be looking at historical patterns at this point and those patterns show that in some years the S&P 500 might gain as much as 20% while in other years it might lose that same percentage. Sometimes the stock market, the S&P and the mutual fund will not deliver the 10% projected. By definition that investment has more inherent risk than the certificate of deposit.
The caveat here is to realize that the CD has some problems too. Remember that one third of what you earn is your tax obligation. If the inflation rate increases you may actually be left with a negative after tax, after inflation balance. This is known as inflation risk and is part of the assessment of risk involved in choosing investments and measuring diversification allocations.
The different risks inherent in owning stocks can be the risk of the market at large. If the market nosedives, stocks will decrease in value. It is important to look at reasons the market gets sour. One reason is rising interest rates. Higher interest rates make fixed income bonds and CDs look better to investors and stunt economic growth. The result is that company profits grow more slowly and may actually begin to fall. There are other things that hurt the market and though some things are not well understood just about anything that shakes the economy or rattles the confidence of the investor will cause a blip in the market.
Protecting against market risk is a matter of diversifying your investments. This means a plan that diversifies within the stock market, bonds, money-market funds, real estate, and commodities. When an investor spreads the risk over many vehicles and segments the likelihood is that when one area is losing value other areas will likely be holding their own or gaining in value.
Other risks include sector risk which means that if you have stock in a company and the entire industry becomes obsolete the stock will quickly lose value. Think what might have happened to the wagon industry when cars arrived on the scene. Actually the more modern example is that the stocks of major drug companies have fallen out of favor in the last few years. The freefall in stock value when a drug on the market is suddenly revealed to have lethal side effects is an example. All pharmaceuticals take some hit as the sector is suddenly seen as unattractive. Again the protection from sector risk is to be diversified so that not all of your investment will be affected.
Managing your own investments can be time consuming especially if you are investing in individual stocks. To properly diversify you would need upward of a dozen stocks. You would need to spend an awful lot of time considering the average earnings and watching earnings estimates, assessing forecasts and impending competition. Bad management can kill an otherwise good company so reassessment every time there is a change at the executive level is imperative. You can do it, but you might prefer to invest in a varied selection of diversified mutual funds. Good choices are funds that invest in large, midsize and smaller firms. Make sure your investments cover a cross section of industries as well as companies within an industry sector.
Investors in today’s global market are looking to foreign investments as well as domestic ones. Foreign stocks and bonds are an advantage when the value of the dollar falls because the investment in Euros, Yen, or whatever other currency gets converted into more dollars. Of course the other side of that coin is, that when the dollar is stronger, it pinches your foreign investments.
Look at the housing market for investment opportunity but beware of the risks. Housing is an inherently local market so study the local scene. If housing prices are rocketing and investors are turning over the homes they just bought a few months ago then the market is demonstrating a higher degree of risk. In a stable slow moving housing market your investment in housing can be expected to appreciate reliably but in a market that shoots up too quickly the bottom can drop out without much warning leaving you with houses you cannot sell for the purchase price and no way to recoup your investment.
Bonds are generally considered secure investments but that will depend on interest rates. There are three main issues with bonds. The first issue is whether the company issuing the bond will be viable and able to pay the interest and of course the face value of the bond at maturity. Knowing the financial health risk of the company is vital in assessing this risk. Second if the interest rates rise and the issuing company calls the bond it may mean taking a hit in the projected return of the bond. Be sure when you buy bond that you are familiar with its call provisions. Third the value of interest payments is totally dependant on inflation. Inflation makes the interest worth less and it makes the principle worth less. Because bonds with a short term interest rate are lower risk than bonds with longer term interest rates savvy investors purchase bonds with staggered maturities. This risk dampening maneuver is called laddering and is part of the diversification strategy. The way it works is you buy bonds that have the same value but that achieve maturity at one year, two year, three year and so on so that if interest rates go down you have higher rates actually locked in with the longer term bonds. If interest rates go up a bond comes due every year so you can reinvest at a higher expected yield.
Knowing the risk isn’t all there is to achieving bigger returns. There are strategies for tweaking your investments to maximize your results. Here are five ways to make it happen:
1. Dump the poor performers; but don’t just dump on the basis of a quick look at raw results. Analyze how your fund has performed in relation to other similarly invested funds. Check with Yahoo finance or www.kiplinger.com to find top performing funds in different categories.
2. Be consistent and moderate. You want funds that have consistent and above average results but remember that the expectation of higher results also mean higher risk. Balance with caution that projected return with the identifiable risk.
3. Fees can eat your profits so read all the fine print and keep the fees manageable. Look at how much a fund charges and the expense ratio to see if the fund sponsor is putting your interests first. The annual fees as a percentage of assets should not exceed 1.5% for stock funds and 0.7% for bond funds.
4. Take advantage of new funds that are performing well. Funds should be managed by proven analysts sponsored by large reputable companies. Large fund houses frequently introduce new funds that do very well.
5. Remember that risk is good in small doses because it provides higher returns if it pays off. Just don’t over balance. Faster growth is associated with higher risk so understand what the trade offs are.
Many people put more thought and planning into their vacations than they do in their retirement plan. Good investment planning means to build your investment plan with a good understanding of risk, a total understanding of what your future goals are, and the commitment to stick to a good plan once you have it all figured out.
