Become a better investor
Lesson in Course: Portfolio management (beginner, 12min )
Investing requires taking risks. What risks should I look out for?
Once we've understood our risk tolerance for each of our investing goals, it's time to understand how our investments can introduce different risks. Let's look at the major categories of risk to our portfolio and the options available to help manage those risks.
A portfolio of stocks benefits from diversification; however, there are certain risks like market risks where diversification will not help. Market risks, also known as systematic risks, affect entire markets or multiple asset classes and cannot be diversified away. These are uncontrollable by investors and are largely related to macroeconomic trends. Below are two exampless we can expect to face.
The change in asset prices as the Federal Reserve sets interest rates describes interest rate risk.
Typically an increase in interest rates impact bond prices more than stocks. Investors can now buy bonds, issued by the government, that pay a higher interest. Those investors will sell the old bonds to buy the new bonds and cause a drop in bond prices.
Interest rate changes tend to create mixed results on the stock market. Some investors see an increase in interest rates as a vote of confidence in the economy and will be happy to buy at higher prices, while a drop in interest rates also creates more money supply, and investors buy more stocks, and the prices rise.
Currency risk is also known as the exchange-rate risk, which impacts trade deficits or surpluses between countries.
Central Banks also use monetary policies to control the money supply and exchange rates. If the value of USDs appreciates against the Euro, American-made goods become more expensive for Europeans. As a result, Europeans will look to other markets and buy fewer American goods, hurting American businesses and the US stock market. A rapidly devalued currency will throw economies into turmoil—we see this happening currently in Venezuela.
The only way to address systematic risk is by using hedging strategies with derivatives or stock options to limit price movements.
On the contrary to market risks, we can have unsystematic, or company-specific, risks. Specific risks, for short, are risks that can be diversified away. If we create a portfolio of 10 companies, it's unlikely all 10 companies will face the same risks. Let's dive into some of these company-specific risks.
Business risk describes everything that is within the four walls of a company.
Examples of business risk include the ability of the company to continue to build great products, make good leadership decisions, hire talent, fend off competition, etc. Business risk is concentrated when an investor only buys stocks in a single or few companies.
Investors can use business risk to their advantage if they have expertise in a specific industry. If Elon Musk starts investing in other electric automobile companies, he will use his experience running Tesla to his advantage.
Political risk, also known as regulatory risk, occurs with a change in leadership in government or policymakers that results in new policies that are either business-friendly or unfriendly.
Examples include laws limiting companies' ability to raise prices or tax rebates in favor of companies. Elizabeth Warren proposed to break up major technology companies and regulate them more heavily. Had she won the Democratic Party nomination, she would represent a big political risk for tech investors.
The relative ease of an investor converting their assets into cash describes liquidity risk.
In well-functioning financial markets like domestic or developed markets, liquidity risk is often very low for most asset classes. Within these markets, the assets with high liquidity risk include physical collectibles, non-fungible tokens, and shares in private companies. In certain circumstances, stock in a company that is going through troubles such as bankruptcy will have a high degree of liquidity risk since no one wants those shares.
Counter-party risk describes the likelihood that the party on the other end of the transaction, the counterparty, will uphold their end of the deal.
The higher the counter-party risk, the less likely the full terms of the deal will be honored. For example, someone who takes a mortgage to buy a home has promised the lenders or investors to pay interest and principal back monthly. If the borrower is unable to meet the monthly payments for whatever reason, this poses as counter-party risk for the lender.
A well-constructed portfolio can help mitigate most of the specific risk without needing to hedge.
Systemic risk, not to be confused with systematic risk, is a very different risk category and can be thought of as a combination of specific risk and systematic risk in the worst way possible. Systemic risk is the possibility that an event or action within a company triggers a domino effect and collapses an entire industry or economy. The term "too big to fail" during the 2008 financial crisis describes the systemic risk. When Lehman Brothers collapsed, the ripple effect froze markets. The government decided to bail out AIG instead of Lehman Brothers to stabilize and minimize the effects of the pending recession.
Outside of well-functioning regulatory bodies, systemic risk is hard to predict and avoid. Hedging can prevent portfolio losses due to the fallout of systemic risk. Government bailouts also are tax-payer-sponsored protections.
To reduce the amount of risk our portfolios are exposed to, diversification is the easiest method to remove a majority of the specific risk. Buying a simple ETF or mutual fund can achieve this. For active investors, having a portfolio of around 10 stocks will greatly help with diversification.
On a practical note, hedging can be costly to do and require deep investment expertise. We don't recommend trying this until we've gained a good upstanding of derivatives and stock options.
Systematic risk is also known as market risk. Market risk effects entire markets or multiple asset classes and cannot be diversified away.
Interest rate risk is the change in the price of an investment because of a change in interest rates.
Currency risk, also known as the exchange rate risk, is the change in the price of an investment because of a change in the exchange rate between two countries.
Specific risk is non-systematic risk and can be diversified away because it only impacts certain companies rather than the market as a whole.
Business risk is the change in price of an investment because of a change that is within the four walls of a company such as the ability to build great products, make good leadership decisions, hire talent, fend off competition, etc.
Political risk, also known as regulatory risk, is the change in the price of an investment because of a change in government leadership or policymakers that results in new policies passed which are either business-friendly or unfriendly.
Liquidity risk is a change in the price of an investment because of a change in the relative ease of converting the investment into cash.
Counter-party risk is the change in the price of an investment because of a change in the likelihood the party on the other end of the transaction, the counter-party, will uphold their end of the deal.
Systemic risk is the possibility that an event or action within a company and trigger a domino effect and collapse an entire industry or economy.