Some Thoughts About Risk

When financial markets are stable and investment portfolio values are increasing, few investors think about the risks associated with their investments. Some investors will get caught up in the frenzy and begin to overweight investments that have done well lately, with the desire to capture as much return as possible. There is little to no thought about why these investments have been appreciating or what the underlying risks are going forward. This behavior, which was evident during the late 90s tech bubble, as well as during the years leading up to the housing market collapse, can lead to significant financial setbacks.

In order to better understand risk, it will be helpful to review a few major asset classes and discuss some of the risks associated with them.

Core bonds.

A subset of the general bond market, core bonds are safer bonds with a low probability of default, but lower expected returns. Core bond examples would include investment-grade bonds issued by corporations (e.g., AT&T), government agencies (e.g., Fannie Mae), the federal government (e.g., U.S. Treasury), and municipalities (e.g., New York State). The biggest single risk to a holder of core bonds is a rising interest rate environment.

In its most basic form, a bond is a loan, and if held until maturity, the bondholder (who is the lender) will not only receive interest payments, but a final payment equal to the amount originally lent. In between when a bond is first issued and when it matures, changes in the level of interest rates could affect the value of that bond at any given point in time. For example, if interest rates increase one percent, a 15-year bond could see its value fall by more than 10%.

The risk associated with rising interest rates can be reduced by choosing shorter-term bonds rather than longer-term bonds. If the investor in the previous example held a three-year bond rather than a 15-year bond, his or her loss would likely have been less than 3% rather than in excess of 10%.

Stocks.

Owners of stock, known as shareholders, participate in the success or failure of the company. If the company does well, shareholders should see the value of their investment increase over time. In addition, if the company pays a cash dividend, shareholders are entitled to receive a portion of that distribution. When buying an individual stock however, there is the possibility that the business will do poorly, or worse, go bankrupt. Over time there have been many iconic businesses that have fallen on tough times and left stockholders with nothing to show for their investment. Often the company’s demise is caused by management missteps, a product becoming obsolete, competition, or unresolved issues with its labor force.

Fortunately, company-specific risk can be reduced and virtually eliminated by increasing the number of stock investments in your portfolio. Unfortunately, the risk inherent to the stock market itself, known as systematic risk, cannot be eliminated. Over the past few years we have seen how major economic events such as the global recession and the instability of the banking system led to large swings in the general level of stock prices. Geopolitical events such as the inability of a foreign government to pay its bills, civil unrest in the Middle East, and war led to stock market sell-offs. Domestic events ranging from the fiscal cliff and sequestration, to budget battles and a government shutdown, all had an effect on stock prices. These types of events have happened periodically throughout history and will repeat in one form or another in the future.

Another risk to investing in stocks relates to the general level of optimism or pessimism of the investing public. An investment can be priced well above its intrinsic value (the actual value of the company based on analysis of its assets, debts, cash flow, etc.) and continue to rise, or priced well below and continue to fall, based purely on the collective fear or greed in the marketplace.

Non-traditional asset classes and strategies.

Non-traditional asset classes and strategies lie outside of the traditional stock and bond portfolios. They include non-core (riskier) bonds, commodities, alternative strategies, real estate, and infrastructure. Each of these investments has its own unique risks.

Non-core bonds (such as foreign bonds, emerging market bonds, and U.S. high yield corporate debt) tend to fluctuate more in price than the safer core bonds previously mentioned. Along with interest rate risk, non-core bonds are more exposed to credit risk. This is the risk of loss of principal or interest stemming from a borrower’s failure to repay a loan. In addition, those non-core bonds whose principal and interest payments are denominated in a foreign currency will have added concerns surrounding changes in foreign currency values. To compensate for the increased risk, non-core bonds tend to pay higher interest rates than core bonds.

When investing in commodities (physical items such as oil, gold, or corn) changes in supply and demand of the underlying commodity can lead to changes in value. For example, an increase in the supply of a commodity, such as a large oil discovery or increased crop yields caused by favorable weather, should cause the price of a commodity to fall. In contrast, a disruption in supply caused by war or a natural disaster should cause the price of a commodity to rise.

When investing in publicly traded real estate, you are purchasing shares of a company that owns real estate (such as shopping centers, apartments, warehouses, office buildings, and hotels) and manages it on your behalf. Rewards for investment include rental income and an increase in property values over time. Risks include changes in the underlying value of the property due to its location and the economic climate surrounding the property. In addition, increased vacancy rates can reduce rental income generated on an underlying property. Also, there is the risk of physical damage to the underlying properties due to vandalism, fire, or natural disasters.

Within the broad category of alternative strategies, there are several different approaches each with different risk/return profiles. Historically, these strategies have often been favored by wealthy individuals and institutions mainly because their returns can be independent of the general direction of the stock market. A few examples would include long/short equity, equity market neutral, global macroeconomic, merger arbitrage, convertible arbitrage, fixed income arbitrage, and tactical asset allocation. While each of these strategies is unique, they tend to exhibit model risk, event risk, liquidity risk, or a combination of the three.

• Model risk: The risk that a financial model used to value a transaction or measure exposure to a particular type of risk fails to perform as it was intended.
• Event risk: The risk surrounding unforeseen and unanticipated events that could result in a loss.
• Liquidity risk: The risk surrounding the inability to buy or sell a security quickly enough, and at a reasonable price, to prevent a loss.

Infrastructure assets such as ports, toll roads, pipelines, transmission lines, cell phone towers, and water utilities have long lives and are required for society to operate and thrive. These assets tend to have stable revenues and little or no competition within the geographic region in which they operate. Unforeseen changes in regulation, however, can result in decreased profitability. Also, these assets tend to be quite expensive and can take years to recoup the upfront building expense. Any changes to end user demand or the useful life of the asset could reduce the value of the investment.

Summary.

It is clear that each of the major asset classes mentioned above (core bonds, stocks, and the various non-traditional asset classes and strategies) have risks. What is beneficial for investors, however, is that these risks can be quite different from one investment to another. What causes one asset class to fall in value may have no effect on a different asset class or cause it to increase in value. As such, when combined properly, the appropriate mix of asset classes and strategies should increase expected portfolio returns, reduce expected portfolio risk, and help an investor reach his or her goals and objectives.