Investing: Risks, Losses, And Uncertainties

Investing is risky business. There are many types of investments, and each comes with its own set of risks. Stocks, for example, may decline in value for a variety of reasons, including lower-than-expected earnings, a change in management, or a shift in consumer tastes. Bonds are subject to interest rate risk, which means that when market interest rates rise, the value of your bonds can decline. Even Certificates of Deposit (CDs), which are generally considered safe, carry what's known as reinvestment risk – the risk that you won't be able to reinvest the proceeds of a maturing CD at the same interest rate.

But not investing also carries risks. If you don't invest, or if you only invest in conservative vehicles, your money may not grow enough to help you reach your long-term goals, such as a comfortable retirement. So, while investing does involve risk, it's important to remember that not investing is also a risk in itself.

Inflation risk

Any asset or income stream that is denominated in money is potentially vulnerable to inflationary risk because it will lose value in direct proportion to the decline in the purchasing power of money. For example, lending a fixed sum of money to be repaid at a later date is an asset that is subject to inflationary risk because the money that is repaid may be worth significantly less than the money that was lent.

Bonds are considered the most vulnerable to inflationary risk. Most bonds have a fixed coupon rate that doesn't increase over time. So, if an investor buys a 30-year bond that pays a 4% interest rate, but inflation skyrockets to 12%, the investor will lose purchasing power with each passing year.

Inflationary risk can be mitigated by building an inflation premium into the interest rate or required rate of return (RoR) demanded for an investment. Some securities, like Treasury Inflation-Protected Securities (TIPS), also adjust their cash flows for inflation to prevent changes in purchasing power.

Liquidity risk

There are two types of liquidity risk: funding liquidity risk and market liquidity risk. Funding liquidity risk is the inability to obtain sufficient funding to meet financial obligations. This is the primary concern of corporate treasurers, who are responsible for ensuring the firm can fund its liabilities. A classic indicator of funding liquidity risk is the current ratio (current assets/current liabilities).

Market liquidity risk, also referred to as asset liquidity risk, is the inability to easily exit a position. For example, an investor may own real estate but, due to poor market conditions, be unable to sell it without accepting a significantly lower price.

Market liquidity risk can be influenced by several factors:

• Market microstructure: Some markets, like commodity futures, are typically deep, while many over-the-counter (OTC) markets are thin.
• Asset type: Simple assets are generally more liquid than complex assets.
• Substitution: If a position can be easily replaced with another instrument, substitution costs are low, and liquidity tends to be higher.
• Time horizon: If a seller is in a hurry, this tends to increase liquidity risk.

Effective liquidity risk management involves ensuring access to sufficient cash, liquid assets, and borrowing lines to meet both expected and unexpected liquidity needs. This can be achieved through strategies such as maintaining a portfolio of high-quality liquid assets, employing rigorous cash flow forecasting, and diversifying funding sources.

The repercussions of unmanaged or poorly managed liquidity risk can be severe and far-reaching, potentially leading to financial losses, operational disruptions, and reputational damage. In extreme cases, liquidity risk can drive a business towards insolvency or bankruptcy.

Concentration risk

For example, an investor might believe that a particular investment or sector will perform better than its peers, and so they make a conscious decision to invest more of their money in that asset or asset class. Alternatively, one of their investments may have performed very well relative to the rest of their portfolio, leading to a greater concentration in that particular asset. Employees may also be tempted to concentrate their retirement savings in the stock of their employer, and investments within the same industry, geographic region, or security type tend to be highly correlated. Certain investments, such as private placements, unlisted direct participation programs, and non-traded real estate investment trusts (REITs), may also be difficult to sell quickly, leading to a concentration in illiquid investments.

To manage concentration risk, investors can diversify across and within the major asset classes, such as stocks, bonds, and real estate. It is important to spread stock holdings among different sectors and ensure that bond portfolios are diversified by issuer and type of bond. Regular rebalancing is also key to ensuring that holdings coincide with investment objectives. Additionally, investors should be aware of the liquidity of their investments and consult a professional if a large percentage of their portfolio is tied up in illiquid securities.

Overall, concentration risk is a significant consideration for investors, as it can lead to amplified losses and negatively impact their financial welfare. By understanding the factors that contribute to concentration risk and implementing diversification and rebalancing strategies, investors can better manage this risk and improve their potential for financial gains.

Credit risk

When an investor purchases a bond, they are essentially making a loan to a corporation or government entity. In return, the bond issuer promises to repay the loan (principal) with interest over a period of time. Credit risk is the chance that the issuing entity will default on the loan, which can occur if the underlying entity goes bankrupt. If this happens, bond investors may receive little to none of their principal investment back.

Government bonds, especially those issued by federal governments, have the least amount of default risk and the lowest returns. Conversely, corporate bonds tend to have the highest amount of default risk but also offer higher interest rates. Bonds with a lower chance of default are considered investment-grade, while those with a higher chance are considered high-yield or junk bonds.

While it is impossible to know exactly who will default on their obligations, properly assessing and managing credit risk can help lessen the severity of potential losses.

Political risk

There are various political decisions that can impact businesses, industries, and the overall economy. These include taxes, spending, regulation, currency valuation, trade tariffs, labour laws, and environmental regulations. Even proposed laws and regulations can have an impact, and they can be set at various levels of government, including federal, state, and local, as well as in other countries.

The impact of political risk on investments is particularly notable in emerging markets. Since the 2008-2009 Global Financial Crisis, macro-political risks in these markets have increased, reflecting the growing importance of top-down analysis in managing emerging market portfolios. The frequency and intensity of political and economic crises highlight the need for a more systematic method of measuring political risk and its influence on market prices.

In conclusion, political risk is a crucial factor for investors to consider, especially when investing in emerging markets. The potential impact of political instability or changes on investment returns underscores the necessity of understanding and managing this type of risk effectively.

Frequently asked questions