RebelCapitalist: Financial Information for the Rest of Us

Risk

Oct 07, 2009 | By: Mr_Blue | (0) Comments | Permalink | Tags: investing, risk

Not the board game, silly. Risk in the context of saving or investing. One of the causes of this financial crisis was how financial conglomerates and investment experts underestimated risk. They plunged into the mortgage market with reckless abandon and ignoring many basic investment principles. We should learn from their mistakes by understanding and appreciating risk.

We have learned from the financial crisis that NOTHING can be taken for granted or NOTHING is guaranteed (ie. real estate prices always go up). Risk is a fact of life in investing (or in general) whether from simple savings account to stocks to investment property. What is the important thing is how we understand it and manage it.

For most of us, risk is the probability of losing “everything” we saved or the probability of our investments losing value. Risk is a relative concept - some investments are more risky than others. This basic concept is often lost or glossed over by people who sell financial products.

Risk can be that of as a ladder with the bottom rung being simple saving accounts then as we move up the ladder investments become more risky - next rung maybe money market accounts and money market mutual funds. Next, maybe U.S. Treasury Securities and municipal and state bonds. Climbing higher could be high quality corporate bonds. Even higher is stocks.

There are different types of risk depending on the investment. Here are just a few:

Market risk - risk that the market (stock or bond) will move against us.

Economic risk - risk that is inherent in the economy

Inflation risk - risk that inflation will negatively impact our investment. This is very important for fixed income securities such as most bonds.

Interest rate risk - risk that the value of an investment will change due to a change in interest rates. Changes in interest rates can directly impact interest rate sensitive investments such as bonds.

Company risk - risk that the company we invest in goes out of business

Operational risk - risk that the company we invest in is not managed properly

There are several ways that investment professionals measure risk but those will be left for another story. Since risk is a relative concept one way to compare riskiness of investments is through the yield or return (APY - annual percentage yield) on the investment. This is the important thing to remember:

Higher the risk - higher the return or yield

There is a direct and positive relationship between risk and return(yield). So, the next time someone (“snake oil”) offers 10% return with little to no risk - we should tell them to take a flying leap.

There is another way to compare risk. Investment professionals often refer to the “risk-free” rate of return. This is a theoretical concept but can be useful for us. The “risk-free” rate of return is the investment that has NO default risk (risk of non-payment on a debt obligation). In practice, the “risk-free” rate of return is often the yield on 1-year U.S. Treasury Bill.

The yield on a 1-year U.S. Treasury Bill can be found in any major financial website - such Yahoo! Finance or Bloomberg.com. The current yield (10/09) on a 1-year U.S. Treasury Bill is: 0.32%.

The theory is that this risk-free rate of return is the basis or starting point and then we add a certain percentage to compensate us for the various risks that we may assume for a particular investment:

Expected return/yield = Risk free rate + Market Risk + Interest rate Risk + Economic Risk + Inflation Risk + Company Risk + Operational Risk

Again, this a theoretical concept that may be helpful in comparing risk of certain investments.

The important thing is that we understand and appreciate investment risks and that we understand the positive relationship between risk and return (yield). Got it.

Good luck.