Thursday, 19 October 2006

The types of Investment Risk

A key component in deciding the asset mix you want to include in your total investment portfolio is "risk". In financial planning terms, market risk is defined as the variability of returns from an investment, or "the uncertainty of a future outcome". Although we are really only concerned by the likelihood of a LOSS, using volatility to measure risk is OK, as the standard deviation of investment returns is used to measure volatility, and this is directly related to the risk of an exceptional LOSS as well as the "risk" of an unusually GAIN.

Total risk = General risk + Specific risk
= Market risk + Issuer risk
= Systematic risk + Nonsystematic risk

The total risk of an asset is a combination of the many possible sources of risk.

Inflation risk - the chance the money you have invested will
decline in real value due to inflation.
Principal risk - the chance that your original investment will
decline in value or be lost entirely.
Credit risk - the chance a borrower will default on an
Market risk - the likelihood that a broad investment market,
such as the bond or stock market, will decline
in value.
Liquidity risk - the possibility you won't be able to sell or
convert a security into cash when you need the
Interest Rate Risk - the variability in a security�s return resulting
from changes in the level of interest rates
Regulation Risk - The risk of a regulatory change that could
adversely affect the stature of an investment
(eg. changes to the tax law)
Business Risk - the risk of doing business in a particular industry
or environment is called business risk
Reinvestment Risk - the risk that dividends/coupons will not be
reinvested, or cannot be reinvested at the same
rate, so that yield to maturity (YTM) isn't attained.
Exchange Rate Risk - the variability in returns on securities caused by
currency fluctuations (aka "currency risk")
Country Risk - the chance of loss due to stability and viability of
a country's economy (aka "political risk")
Valuation Risk - the chance that a an investment is overvalued
(eg. bubbles)
Timing Risk - the chance that other factors cause you to buy or
sell an investment at an inappropriate time
Forced Sale Risk - the chance that an investment is liquidated
involuntarily eg. takeover, fund closure

Some of these risks overlap eg. the principal risk may be a combination of market risk, business risk and regulation risk. It is not possible to measure of estimate some of these risks accurately, but it is still important to mentally run through this list whenever you are considering a new investment.

Standard deviation is a measure of the total risk of an asset or a portfolio, including therefore both systematic and unsystematic risk. For any investment, the "total risk" can be calculated from data on periodic (daily or monthly) valuations (prices) using the formula:

std dev = SQRT[{1/N}xSUM(Xi-mean)^2]
N is the number of data points,
Xi is the ith measured value,
mean is the mean (average) of all the values,
and the SUM is for all values (for i=1 to N).

Standard deviation for many investments is available online or in magazines. If you have an investment and have periodic (eg. daily) unit prices you can caluculate the standard deviation yourself. A tutorial on how to calculate standard deviation for your investment data using excel is available here.
Typically, the standard deviation of the annual returns for various asset classes are as follows:
    Money market (cash): 2%-3%
    Short-term bond: 3%-5%
    Long bond: 6%-8%
    Domestic stocks (conservative): 10-14%
    Domestic stocks (aggressive): 15%-25%
    Foreign stocks: 15%-25%
    Emerging Markets stocks: 25%-35%

A couple of points to be in mind are that
a) standard deviation is a measure HISTORIC risk - ie. if you use this in your planning, you are automatically assuming that risk in the future will continue at the same levels as in the past - this isn't always true (the collapse of several hedge funds provide examples of coming undone when risk levels suddenly change).

"Although standard deviations based on realized returns are often used as proxies for expected standard deviations, investors should be careful to remember that the past cannot always be extrapolated into the future without modifications. Historic standard deviations may be convenient, but they are subject to errors. One important point about the estimation of standard deviation is the distinction between individual securities and portfolios. Standard deviations for well- diversified portfolios are reasonably steady across time, and therefore historical calculations may be fairly reliable in projecting the future. Moving from well- diversified portfolios to individual securities, however, makes historical calculations much less reliable. Fortunately, the number one rule of portfolio management is to diversify and hold a portfolio of securities, and the standard deviations of well-diversified portfolios may be more stable."
- Learing for Life.

b) you had to pick a particular period to use for calculating risk - did you use data for the past year, past 10 years, all available data?

If you have a figure for the risk level of a particular investment, and know its expected rate of return, and its covariance with the other investments in your portfolio you could then work out where your current/planned asset allocation sits in relation to the efficient frontier, and make any sensible adjustments.

Your Tolerance for Investment Risk

Each individual investor has a different level of tolerance for risk. This may depend on your age, salary and expenses, health, family, and personality.
Conservative investors are more concerned with safety of principal and minimizing risk, and can accept a lower rate of return in exchange for added peace of mind.
Aggressive investors prefer to maximize the return on investment with a more flexible strategy, and are willing to accept a higher degree of risk.

You should ask yourself the following questions to assess your risk tolerance.
- What Are Your Investment Goals?
- How much you can invest, and what rate of return on investment will you need to achieve these financial goals?
- When Will You Need the Investment Income? ie. What investment timeframe are you looking at?
- Are You Comfortable with the Possibility of Losing Money?

Once you know your own risk tolerance, you are in a position to evaluate any new investment in light of it's expected risk and return.

One school of thought is that it is best to be more aggressive and take more risks when you are starting out/younger as you will have more time to "catch up" if things go wrong. I personally think that even young investors should start out with more conservative investments and then start to add more risky investments into their portfolio over time. This way you'll get to know your risk tolerance based on actual experience rather than questionaires etc.

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