Risk is an odd word. It is by far one of the most popular financial topics to discuss with clients. Society uses it as if we have a perfect understanding of its meaning and the news media repeats it with great power and authority.
And yet, we have never seen a word so mis-used and misunderstood.
The general public, and experts alike, refer to “risk” as a universal term. However, that is a gross oversimplification. There is no such thing as “universal risk.” When we discuss this with clients they give us a confused look—like we have three heads. Depending upon how you think about the matter, there are at least ten commonly identified types of risk. As such, the word “risk” should always be preceded with an adjective describing the type of risk we are addressing.
For instance, default, or business, risk comes when one investment stumbles (think Enron). Usually, diversification with 20 to 30 companies alleviates the vast majority of this type of risk. Market risk comes merely from being exposed to a broad class of assets—such as the stock market. Recall how correlated the world’s financial markets were in 2009. Even if you held high-quality stocks in 2009, they still fell significantly.
The stock market is very volatile—especially over short periods of time. During the average year, the stock market fluctuates 14 points—plus or minus.
However, sometimes the market gets very irritable. As such, over a two-year period the market has lost as much as 60%. However, the wise investor will step back and recognize that a drop in the price of a stock does not necessarily have anything to do with how much in earnings or sales a given company produces.
Company specific risk and general market volatility are the types of risk most of us are referencing when we talk about “risk”.
However, it’s not that simple.
The greatest risk, in our opinion, comes from leverage—or borrowing too much. Borrowing money can aid in making investments (a house is a perfect example), there are limits. Too much leverage (whether personal, corporate or governmental) incurs risk that an unexpected event may cause our cash flow to dry up—leaving little ability to service the debt. As such, leverage can quickly become a house of cards.
Inflation or purchasing power risk occurs when assets fail to keep pace with increases in the cost of goods and services. Over the past 40 years, the stock market has produced after-inflation returns of more than 6% while the bond market has produced negative returns. With record low interest rates, it is easy to see that net of taxes and inflation, fixed income investments may seem safe—but actually carry significant risk. Since property taxes, food and health care have all risen significantly, this type of risk affects virtually all Americans.
With the ten-year Treasury bond paying a slim 2% interest, many fixed income investors face interest rate risk. Assume you buy a ten-year Treasury and one year later interest rates increase–the same Treasury bond now commands 6% interest. Obviously, your 2% is inferior to a 6% yield. If you go to sell your existing bond you do so at a loss to entice someone to buy it when compared to other options. Interest rate risk occurs when rates go up making existing fixed income assets inferior in comparison.
Land and private businesses create liquidity risk. Unlike 100 shares of Pepsi stock, there is not a constant stream of willing people wanting to buy land each day. As such, when cash is most needed, liquidity risk—from land or any other non-publicly traded asset—occurs. To entice a buyer you may have to lower your asking price—or wait months or years to find any buyer.
Although this discussion exemplifies a few common types of risk, a smart investor should also evaluate the impact of political, currency, taxation and credit risks too.
Lastly, it should be obvious that risk is not a one-size-fits-all term. The more knowledgeable an investor is, the better equipped they are to deal with the variety of risks facing all of their assets. Risk cannot be avoided. Rather, it must be properly identified and then managed accordingly.