Investing requires taking risks. What risks should I look out for?
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.
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.
Within company-specific risk, we have a total of four different risk types with business risk being one of them.
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 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.
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.
Depending on new policies, the demand for an investment can plummet causing liquidity risk.
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.
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.
The higher the counterparty risk, the less likely the full terms of the deal will be honored.
A well-constructed portfolio can help mitigate most of the specific risk without needing to hedge.
A portfolio of stocks benefits from diversification; however, there are certain risks like market risks where diversification will not help.
These are uncontrollable by investors and are largely related to macroeconomic trends. Interest rate risk is a type of systematic risk.
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.
Central Banks also use monetary policies to control the money supply and exchange rates.
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, 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.
Outside of well-functioning regulatory bodies, systemic risk is hard to predict and avoid.
Here's a story of a recent fallout due to systemic risk.
Hedging can prevent portfolio losses due to the fallout of systemic risk. Government bailouts also are tax-payer-sponsored protections.
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.