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Risks to our portfolios

Lesson in Course: Portfolio management (beginner, 12min)

Investing requires taking risks. What risks should I look out for?

Eureka!

What it's about: The different types of risk we face as an investor.

Why it's important: Understanding which risks can be managed will help us know what to do in different market cycles.

Key takeaway: Company specific risks can be diversified away.

Once we've understood our risk tolerance for each of our investing goals, it's time to understand how our investments can introduce different risks. Let's look at the major categories of risk to our portfolio and the options available to help manage those risks.

Specific risk

We know that diversification helps reduce the risk for us.  If we create a portfolio of 10 companies, it's unlikely all 10 companies will face the same risks. The risk we are managing through diversification is called company-specific risk

What is Specific risk?

Specific risk is non-systematic risk and can be diversified away because it only impacts certain companies rather than the market as a whole.

Within company-specific risk, we have a total of four different risk types with business risk being one of them.

What is Business risk?

Business risk is the change in the price of an investment because of a change that is within the four walls of a company such as the ability to build great products, make good leadership decisions, hire talent, fend off competition, etc.

Examples of business risk include the ability of the company to continue to build great products, make good leadership decisions, hire talent, fend off competition, etc. 

Business risk happens within the four walls of a company

Business risk is concentrated when an investor only buys stocks in a single or few companies. Investors can use business risk to their advantage if they have expertise in a specific industry. If Elon Musk starts investing in other electric automobile companies, he will use his experience running Tesla to his advantage—assuming he doesn't run into political risk.

What is Political risk?

Political risk, also known as regulatory risk, is the change in the price of an investment because of a change in government leadership or policymakers that results in new policies passed which are either business-friendly or unfriendly.

Examples include laws limiting companies' ability to raise prices or tax rebates in favor of companies. Elizabeth Warren proposed to break up major technology companies and regulate them more heavily. Had she won the Democratic Party nomination, she would represent a big political risk for tech investors.

Newly elected officials can be a risk to business

Depending on new policies, the demand for an investment can plummet causing liquidity risk.

What is Liquidity risk?

Liquidity risk is a change in the price of an investment because of a change in the relative ease of converting the investment into cash.

In well-functioning financial markets like domestic or developed markets, liquidity risk is often very low for most asset classes. Within these markets, the assets with high liquidity risk include physical collectibles, non-fungible tokens, and shares in private companies. 

Market makers help balance liquidity

In certain circumstances, stock in a company that is going through troubles such as bankruptcy will have a high degree of liquidity risk since no one wants those shares.

What is Counterparty risk?

Counterparty risk is the change in the price of an investment because of a change in the likelihood the party on the other end of the transaction, the counterparty, will uphold their end of the deal.

The higher the counterparty risk, the less likely the full terms of the deal will be honored. 

Counterparty risk example

 For example, someone who takes a mortgage to buy a home has promised the lenders or investors to pay interest and principal back monthly. If the borrower is unable to meet the monthly payments for whatever reason, this poses a counterparty risk for the lender.

Regulated authorities work to minimize counterparty risk

A well-constructed portfolio can help mitigate most of the specific risk without needing to hedge.

Systematic risks

A portfolio of stocks benefits from diversification; however, there are certain risks like market risks where diversification will not help. 

What is Systematic risk ?

Systematic risk is also known as market risk. Market risk affects entire markets or multiple asset classes and cannot be diversified away.

These are uncontrollable by investors and are largely related to macroeconomic trends. Interest rate risk is a type of systematic risk.

What is Interest rate risk?

The change in asset prices as the Federal Reserve sets interest rates describes interest rate risk. 

A rise in interest rates can cause a drop in prices

Typically an increase in interest rates impact bond prices more than stocks. After an increase, investors can now buy bonds, issued by the government, that pay a higher interest rate. The same investors will sell old bonds to buy the new bonds and cause a drop in existing bond prices. Interest rate changes tend to create mixed results on the stock market. Read about bond movements and stock prices.

The other systematic risk is currency risk.

What is Currency risk ?

Currency risk, also known as the exchange rate risk, is the change in the price of an investment because of a change in the exchange rate between two countries.

Central Banks also use monetary policies to control the money supply and exchange rates. 

Central Banks use monetary policy to control money supply

If the value of USD appreciates against the Euro, American-made goods become more expensive for Europeans. As a result, Europeans will look to other markets and buy fewer American goods, hurting American businesses and the US stock market. A rapidly devalued currency will throw economies into turmoil—we see this happening currently in Venezuela. 

The only way to address systematic risk is by using hedging strategies with derivatives or stock options to limit price movements. 

 

Systemic risk

Systemic risk, not to be confused with systematic risk, is a very different risk category and can be thought of as a combination of specific risk and systematic risk in the worst way possible. 

What is Systemic risk?

Systemic risk is the possibility that an event or action within a company can trigger a domino effect and collapse an entire industry or economy.

Outside of well-functioning regulatory bodies, systemic risk is hard to predict and avoid. 

The government is the only thing that can help against systemic risks

Here's a story of a recent fallout due to systemic risk.

Lehman brothers collapse

The term "too big to fail" during the 2008 financial crisis describes the systemic risk. When Lehman Brothers collapsed, the ripple effect froze markets. The government decided to bail out AIG instead of Lehman Brothers to stabilize and minimize the effects of the pending recession. 

 Hedging can prevent portfolio losses due to the fallout of systemic risk. Government bailouts also are tax-payer-sponsored protections.

 
 

Actionable ideas

To reduce the amount of risk our portfolios are exposed to, diversification is the easiest method to remove a majority of the specific risk. Buying a simple ETF or mutual fund can achieve this. For active investors, having a portfolio of around 10 stocks will greatly help with diversification.

On a practical note, hedging can be costly to do and require deep investment expertise. We don't recommend trying this until we've gained a good upstanding of derivatives and stock options.

Glossary

What is Systematic risk ?

Systematic risk is also known as market risk. Market risk effects entire markets or multiple asset classes and cannot be diversified away.

What is Interest rate risk?

Interest rate risk is the change in the price of an investment because of a change in interest rates.

What is Currency risk ?

Currency risk, also known as the exchange rate risk, is the change in the price of an investment because of a change in the exchange rate between two countries.

What is Specific risk?

Specific risk is non-systematic risk and can be diversified away because it only impacts certain companies rather than the market as a whole.

What is Business risk?

Business risk is the change in the price of an investment because of a change that is within the four walls of a company such as the ability to build great products, make good leadership decisions, hire talent, fend off competition, etc.

What is Political risk?

Political risk, also known as regulatory risk, is the change in the price of an investment because of a change in government leadership or policymakers that results in new policies passed which are either business-friendly or unfriendly.

What is Liquidity risk?

Liquidity risk is a change in the price of an investment because of a change in the relative ease of converting the investment into cash.

What is Counterparty risk?

Counterparty risk is the change in the price of an investment because of a change in the likelihood the party on the other end of the transaction, the counterparty, will uphold their end of the deal.

What is Systemic risk?

Systemic risk is the possibility that an event or action within a company can trigger a domino effect and collapse an entire industry or economy.