THE SEVEN RISKS FOR INVESTORS

Jurg M. Lattmann

No-risk investments are a myth. There is no living without risk; risk is a part of life. The more familiar we are with the risks involved in an undertaking, the more precautions we can take. The more we know about risks to our personal property and assets, the more realistic we are in our goals and the greater our chances of success in achieving them.

The real dangers are from unknown risks. Once we know the risks, we can turn them into opportunities. At the very least, we can develop recipes for minimizing them, and in the worst case, we can limit the damage if we are hit and thereby avoid a total investment disaster. This last certainly makes it worth learning about risk.

Every investor should know the various types of risk associated with investing in financial instruments. Formulating an investment strategy which focuses only on returns ignores the fact that certain risks are inextricably tied to an asset’s performance. Here are a number of the risks to which financial assets are exposed.

1. Price Risk

Since asset prices reflect all the different risk factors affecting supply and demand for an asset, the most generalized risk faced by an investor is price risk. This risk is also related to the volatility of an asset’s price, i.e. how widely it swings up and down. But since an upward movement is generally a welcome occurrence, the concern in price risk is for a decline in the price of an asset or in the entire portfolio’s market value — the downside risk.

For common stocks, the primary source of price risk is in the general fluctuations of the stock market itself. For bonds, the risk is of a rise in interest rates which leads to a fall in bond prices. The longer the maturity of the bond, the more its price will change in response to a change in interest rates.

Price risk is the primary threat in the short-run for investors. If you are not forced to sell, there is the likelihood of prices recovering given enough time. A buy-and-hold strategy is thus called for. Longer holding periods will moderate the impact of volatile prices.

2. Default Risk

This is the risk that an issuer of a security may be unable to meet the terms of the issue. Also referred to as credit risk, this may mean that the issuer cannot pay interest in a timely manner or cannot pay the principal at the end of the agreed upon period. Default risk may also arise as a result of business risk. A deterioration in a company’s business prospects will adversely affect the value of its outstanding stock and bond issues.

Default risk can be reduced by diversifying your investments within an asset class. Your stock holdings should, for example, be distributed in stocks among different industries.

3. Liquidity Risk

A liquidity risk exists when there is a chance that you will have to sell an investment below its true value or can find no ready buyer at that value. This is also called marketability risk. If you have to take a loss in order to sell immediately as opposed to waiting until an appropriate bid comes along, then the investment is illiquid. Similarly, an investment is illiquid if significant time and expense are required to find a suitable buyer. Liquid assets are then those assets that can be sold quickly and at a low cost.

Small company stocks as well as emerging-market stocks carry a high degree of liquidity risk because of the low volume of stocks traded in these markets.

The way to reduce the impact of liquidity risk is to invest in assets with varying time frames. Then your cash flow will not be significantly affected by hard-to-dispose of assets. Or you might choose to invest in liquid vehicles for these assets: buy a real estate investment trust (REIT) rather than a piece of real estate.

4. Market Risk

Any stocks or mutual funds you own will invariably suffer losses if the stock market takes a plunge. And so will any bonds you own if the bond market collapses. The risk that the fortunes of the general market for an asset will adversely affect that particular asset is market risk. Business cycles and market trends — including market psychology — are the primary factors affecting the risk of investing in a market. For example, at the start of an economic boom when inflation and interest rates are low, bond markets will likely not do as well as stocks. Or when U.S. stocks are in a cyclical decline, foreign stocks may be heading up in tandem with business cycles in the respective countries. Political conditions can also affect the market’s behavior. The run up to elections or times of political crisis bring increased uncertainty and therefore risk.

Diversifying into different asset categories and different countries is key to reducing market risk. Additionally, a more active approach relies on assessing the right place to be at the right time and allocating a larger proportion of your assets (over- weighting) to those markets.

5. Reinvestment Risk

This is the risk that comes from the possibility that an investment will have to be reinvested at a lower interest rate or at a higher price. While an increase in interest rates results in a fall in bond prices, a decline in rates presents a reinvestment risk for investors. Many bonds contain a provision which allows issuers to redeem or call in all or part of the issue before the maturity date.

Lower interest rates usually give issuers an incentive to call in debt in order to be able to refinance at the lower rates. But this forces investors to reinvest the cash proceeds at lower rates as well. For a portfolio of stocks, a future increase in stock prices poses the risk of having to reinvest profits or dividends at a higher price.

A regular review of your portfolio will serve to moderate reinvestment risk. What has changed from the time you made the investment? Take the opportunity to adjust your investment strategy and rebalance your portfolio.

6. Inflation Risk

A risk inherent in all assets is inflation risk. Take an investor holding a one-year bond with a maturity value of $5,000 and an interest rate of 6%. At the end of the year, the cash proceeds will amount to $5,300. If inflation over that year is 4% then your real return (adjusted for inflation) is substantially less than 6%. In this case it is $5,300 divided by 1.04 or $5.096. Inflation reduces your returns because the cash flow from your investments will buy fewer goods than before. Inflation risk or purchasing power risk is the risk that inflation will result in a negative real return.

Over periods of twenty years or more, studies have shown that stocks outpace inflation far more than bonds or Treasury bills. But in times of high inflation, gold and other hard assets are the best hedge. And since inflation affects a currency’s strength vis- a-vis other currencies, investing in low-inflation countries is one way to reduce purchasing power risk.

7. Exchange Rate Risk

The value of an asset denominated in a foreign currency will fluctuate in its conversion to a base currency. In particular, the value of an asset denominated in an appreciating currency rises and that in a depreciating currency falls. If the Swiss franc appreciates, a U.S. investor who holds a Swiss security will have a gain. If an investor receives income from a Japanese yen bond and the yen appreciates, the investor will receive more dollars. The risk for an investor amounts to the possibility that the U.S. dollar will have risen in relation to a foreign currency by the time payments are to be received, resulting in dollar losses.

A number of factors give rise to exchange rate or currency risk. These are related to supply and demand conditions for foreign currencies relative to a base currency. A dollar-based investor, for example, should consider such factors as inflation rates, interest rates, savings rates, fiscal balances, the current account balance (the balance of imports and exports of goods, services and other transfers), and economic growth in the respective foreign economy relative to the United States.

Currency markets have also increasingly been influenced by the hedging practices of large institutional investors and investment fund managers. In trying to anticipate exchange rate movements, large amounts of currencies are bought and sold, with significant short-term consequences for exchange rates. Central bank intervention to support a currency, particularly when coordinated among the central banks of the world’s major economies, is also an important determinant of short-run exchange rate fluctuations. In the long-run, however, economic fundamentals such as inflation rates and deficits or surpluses in the country’s financial accounts are the most important determinants of a currency’s strength.

Mutual funds and large companies with substantial foreign currency exposure often take measures to hedge the impact of currency movements. So when you invest in these funds or companies you are already hedged to some degree. In the long-run, the best strategy to reduce currency risk is to diversify among different countries, choosing in particular those countries with a record of low inflation, high savings rates and healthy balances in fiscal and trade accounts.

The bright side of risk

That’s seven risks inherent in investing. They affect financial assets in different ways. The so-called low-risk assets (such as Treasury bills and money-market mutual funds) prevent capital losses but have little potential for appreciation and — in the long run — are most vulnerable to purchasing power risk. On the other hand, so called high-risk aggressive growth stocks are not good vehicles for ensuring the safety of your principal in the short-term but are a good way to hedge against inflation in the long run.

Depending on your time horizon you should allocate more or less money in instruments that have long-term profit potential (stocks) or assets that can secure your capital and income today (cash and fixed-income assets).

But whatever you do, don’t be daunted by the risks. An investor should treat risk as an entrepreneur treats a new business venture — as an opportunity to exploit. The flip-side of taking greater risks, as modern portfolio theory points out, is greater financial reward. With time on your side and a carefully thought-out global investment strategy, the risks themselves can be tamed to maximize your long-term profits.

If financial assets were completely riskless, there would be no need for modern portfolio theory. In addition, if gathering information — both historical and current — on the universe of riskless investments were quick and easy, investors could choose the one investment with the highest return, the highest income, whatever criteria they may have. The reality, however, is none of these things.

Modern portfolio theory is thus an essential tool for investors. It recognizes that assets have risks. With the help of today’s computer technology, it helps to organize information about assets and calculate risks. Finally, it offers investors a way to reduce this risk and so increase potential returns.

The way shown by theory is through portfolio diversification. Diversifying among different countries, for example, has been proven to enable investors to earn higher returns. Numerous studies using the general framework of modern portfolio theory also point to longer holding periods for investments as a way to profit from high-return but highly volatile equities. A properly structured portfolio will take all these elements into account.

Jurg M. Lattmann is a Swiss investment counsellor and expert in Swiss annuities.

More information on international investment can be found at The Offshore Entrepreneur .