Investment Risks Flashcards
Interest Rate Risk
Interest rate risk is defined as “the risk of fluctuations in security prices due to changes in the market interest rate.” Regardless of their source, interest rate changes can mean bad news for bond investors. Changes in interest rates affect the price of bonds inversely. If interest rates increase, new bonds will have better coupon rates than existing bonds. Therefore, the market price of the existing bond will decrease. The good news is that if interest rates decrease, because existing bonds will have higher coupon rates than new bonds, their market value will be worth more.
As interest rates rise, investors will demand a higher return for all investments, including stocks. What you can earn from one investment will determine what you demand from another. Unfortunately, because increases in interest rates affect all securities, it’s impossible to eliminate interest rate risk. Therefore, interest rate risk is a type of systematic (non-diversifiable) risk.
In addition to the clear impact on bonds, keep in mind that interest rate risk flows through other investments as well. For Preferred stock the reaction will be similar to bonds. As rates of new preferred stock issuance increases, the price will adjust for existing securities.
The impact on common stock is tougher to decipher. In general, the cause for rising rates is more important here. Leaving that aside, remember that shareholders receive earnings from a company after all expenses (including interest cost) is paid. If rates increase, a company may have less earnings left to distribute, all else equal. This is why interest rate risk exists in all securities.
Reinvestment Risk
This type of risk refers to the inability of the investor to know the interest rate at which the proceeds from a maturing investment can be reinvested for the remainder of its holding period.
For example, if an investor with a six-month holding period buys a 90-day T-bill, he or she is taking on the risk that interest rates available in 90 days may be less than what he or she is currently getting.
- Investor with a six-month investment time horizon buys a 90-day T-bill.
- T-bill matures and the investor receives principal and has 3 months remaining to the investment horizon.
- Beyond Position Investor may or may not receive the same interest rate for the rest of the time horizon. The - – interest available in 3 months may be the same, more or less than 5%.
Inflation Risk
Another source of systematic (nondiversifiable) risk is inflation. Inflation risk reflects the likelihood that rising prices will eat away the purchasing power of your money. This risk is especially present in long-term bonds, wherein the par value paid - say twenty years down the road - will only provide a fraction of the purchasing power available today for an equivalent amount of money. For example, even at an average rate of 3% inflation over a twenty-year period, $1,000 received 20 years from now would only be worth $553 in today’s dollars.
Unexpected increases in inflation may cause a financial plan that appears to be solid to fall short in achieving its goals. Fortunately for stock investors, over long periods of time, common stocks have produced a return well above the rate of inflation, thereby preserving the purchasing power of your money.
Business Risk
Business risk is specific to the stock or bond that the business issues. Business risk is a type of unsystematic or diversifiable risk. Most stocks and corporate bonds are influenced by how well or poorly the company that issued them is performing. Business risk deals with fluctuations in investment value that are caused by good or bad management decisions, or how well or poorly the firm’s products are doing in the marketplace.
Tax Risk
Tax risk in investment planning is defined as the investor being burdened with an unexpected tax liability. This risk is considered to be a diversifiable, unsystematic risk due to the fact that this risk is borne in asset-specific situations. An investor can reduce this unsystematic risk through diversification by buying multiple stocks (with or without dividends), different asset classes (bonds or stocks), different locations (US or foreign), even different types of bonds (munis or corporates) so that the overall tax risk in a portfolio is reduced. By owning multiple stocks for example, one can reduce tax risk by tax loss harvesting, offsetting gains and losses, selling gains for long-term instead of short-term tax liabilities.
By far, the most likely asset class containing tax risk is any type of pooled investment. In particular, mutual funds - by their very nature, contain considerable tax risk. The unrealized capital appreciation of many mutual funds represents a certain tax liability. To make matters worse, the new investors of a fund with significant unrealized capital gains will necessarily subsidize the tax liability of the fund’s long-term investors. Capital gains distributions will be distributed pro rata, based on the number of shares held.
Another example of tax risk for mutual funds is a simple dividend distribution. If you know that a fund will be trading ex-dividend in two days, you would not buy the fund today. If you did, you would be essentially “buying” a tax liability. Even if you held the fund for a month prior to an annual dividend distribution, you are subsidizing the shareholders tax liability that held the fund for the entire year prior to the annual distribution. The pro rata distribution is strictly based on the number of shares held, and is not sensitive to holding periods.
Investment Manager Risk
Investment manager risk is asset-specific and therefore is considered to be a diversifiable, unsystematic risk. As with tax risk, pooled investments, by their nature, are where this risk is most acute. Anytime an investor delegates investment management responsibility for their portfolio (or fraction thereof) to an investment manager, the investor will be exposed to this risk.
A subtle but good example of this risk is style drift. For example, an investor allocates a certain portion of their equity holdings to large-cap value stocks. In turn, the investor purchases ABC large-cap value fund. Over the course of the year, ABC’s fund manager, feeling pressure to enhance the fund’s returns, begins purchasing small-cap growth stocks. The investor, without even being aware of it, has now drifted outside the designed allocation parameters for the equity portion of their portfolio.
Financial Risk
Financial risk is associated with companies’ capital structure (how the company is financed). Typically, the focus is based on the use of debt by firms. As a firm takes on more debt, it also takes on interest and principal payments that must be made regardless of the firm’s performance. If the firm can’t make the payments, it could go bankrupt. Thus, how a firm raises money affects its level of risk. Financial risks are specific to the company and therefore are unsystematic (diversifiable).
In addition to the total amount of debt, investors today are also aware of risk that comes with convertible securities and dilution to shareholder equity. As firms get more creative with financing this has become a bigger financial risk.
Consider what happens when a person applies for a mortgage. The lender would conduct an analysis of the applicant’s ability to make payments to confirm they can pay; this same diligence should be done on companies one would invest in.
Liquidity Risk
Liquidity risk deals with the inability to sell a security quickly and, most importantly, at a fair market price. The difference between liquidity and marketability is in the fair market price. Marketability refers to the ability to sell something. Liquidity not only means the ability to convert the asset to cash quickly, but also without a significant loss of the principal.
For investments that are infrequently traded, such as the stocks of small companies and many small issue bonds, it can be hard to find a buyer. This can be especially challenging in volatile markets when dislocations between buyers and sellers occur. Sometimes it’s impossible to find a buyer at a fair market price, and you wind up having to sell for less than the asset’s worth—sometimes even for a significant loss. Liquidity is very important for emergency funding. Therefore, assets with great liquidity risks would not be appropriate for emergency fund investment. For example, a house has high liquidity risks because it cannot be converted to cash quickly. Liquidity risk is unsystematic and can be diversified. You should have an asset allocation plan that allows enough liquidity for your total portfolio to withstand difficult markets and life events.
Imagine if you held shares of Enron stock. When the company was doing well on paper and adored by the press and the investment community, the stocks were probably very liquid. However, as the scandal of unethical business practices unfolded, it would have been very difficult to find a buyer for your shares without giving up a significant amount of principal.
This is not just a risk to stocks, keep in mind bonds, especially some municipal bonds that have thin markets can experience high degrees of liquidity risk and price dislocation. This has been seen in both the 2008 financial crisis and again in March of 2020 during the global COVID-19 pandemic. Investors holding these bonds felt they were conservative investments until they realized the losses they would face when trying to sell during market duress.
Market Risk
Market risk is associated with overall market movements. There tend to be periods of bull markets, when most stocks seem to move upward; and times of bear markets, when most stocks tend to decline in price.
The same tends to be true in the bond markets. These periods may be a result of changes in the economy, changes in the mood of investors, or changes in interest rates. Market risk and interest rate risk are examples of overlap in sources of risk.
Market risk is synonymous with systematic risk or nondiversifiable risk. Market risk is measured by beta and is expressed as having a beta of one.
Political and Regulatory Risk
Political and regulatory risk results from unanticipated changes in the tax or legal environments that have been imposed by the government. A company may have to spend a large amount of money in order to comply with new regulations. On the upside, changes in federal or state tax laws may lead to more deductions for a company or for individual taxpayers.
Regulatory risks may be unsystematic (diversifiable) depending on the size and scope of the regulation change. Tax law changes may affect all investors. Changes in environmental laws such as hazardous waste disposal would only affect those companies that dispose hazardous waste.
This has become a significant focus for all investors big and small. As acceptance of Environment, Social, and Governance (ESG) investment focus has grown more mainstream, the assumption has become that companies that do not adapt will face significant regulatory risk as environmental protections become stricter. Companies may have to spend significant earnings to adapt, which would lower returns to shareholders. In addition, some business models (business risk) may become obsolete due to these regulatory changes.
Consider a small town that changes the regulation on the size of home septic tanks. Although septic tank companies and installers may make a large profit from replacing septic tanks for everyone’s homes, the large expenditure may force some homeowners to take out a small loan.
Exchange Rate Risk
This type of risk refers to the variability in earnings resulting from changes in exchange rates. For example, if you invest in a German bond, you first convert your dollars into German euros. When you liquidate that investment, you sell your bond for German euros and convert those euros into dollars. What you earn on your investment depends on how well the investment performed and what happened to the exchange rate.
Imagine you went to Canada for a week’s vacation. The day you leave you exchanged your US dollars for Canadian dollars at an exchange rate of US$1 = CAN$1.75. On the last day of your vacation, you wanted to exchange what you had left in Canadian currency back to US dollars. You discovered that during your vacation, the US dollar became stronger against the Canadian dollar and the exchange rate changed to US$1 = CAN$2. In this scenario, you assumed the exchange rate risk that the US dollar became stronger than the Canadian dollar. This lowered the amount of US dollars that you received back for your Canadian currency.
Sovereign Risk
Investors in a foreign country should evaluate the possibility that the foreign country’s government could collapse, its legal system could be inadequate or corrupt, its police force may not be able to maintain order, the settlement process for securities transactions breaks down occasionally, or other problems arise.
This is a particular risk in emerging market investments where governments have historically maintained some level of control in private companies. There are still a large number of State-Owned Enterprises (SOEs) in the market today. These are companies that trade publicly but have government control or government shareholders in addition to public ones. This has existed heavily in the energy and oil sectors.
Call (Prepayment) Risk
Call risk is the risk to bondholders that a bond may be called away before maturity. “Calling” a bond refers to redeeming the bond early. Many bonds are callable. When a bond is called, the bondholder generally receives the face value of the bond plus one year of interest payments. This risk applies only to investments in callable bonds.
The reason a company may call their outstanding bond issues is that the current interest rates are lower than what the outstanding issue pays in coupon rates. Therefore, the company would lower its interest payable by calling its bonds and issuing new ones at lower coupon rates. The risk for the investor is that once they receive the bond’s par value, they must now invest it in an environment of lower interest rates for the remainder of their investment time horizon.
Prepayment risk is similar to call risk in that it refers to mortgage payers paying off their mortgage early. A common practice for this is when interest rates are low and homeowners refinance their homes at lower rates. This causes debt instruments made of mortgages such as GNMAs to accelerate the amount of principal returned to the investor. Again, the investor receives his or her original investment earlier than anticipated and at a time when the interest rates are lower.
Call risk and prepayment risk overlap with reinvestment risk. Instead of the investor selling early or purchasing instruments that mature before their investment time horizon, this is a case of the investor being forced out of their position prematurely during their holding period.
Probability Analysis
Quantitative methods underlie most of the concepts of risk assessment and all of the investment statistics we use in investment planning. By far, one of the most commonly used applications under the term probability analysis is that of a normal distribution or normal curve. This symmetrical bell-shaped probability curve is used to interpret standard deviation, semi-variances and the important concept of downside risk.
Normal Distribution
The symmetrical, bell-shaped distribution known as a normal distribution plays the center role in the mean-variance model of portfolio selection. The normal probability distribution is also used extensively in financial risk management. The normal distribution has the following characteristics:
Its shape is perfectly symmetrical.
Its mean and median are equal.
It is completely described by two parameters - its mean and variance.
The probability of a return greater than the mean is 50%.
The probability of a return less than its mean is 50%.
There is approximately a 68% probability that the actual return will lie within + / - one standard deviation from the mean.
There is approximately a 95% probability that the actual return will lie within + / - two standard deviations from the mean.
There is approximately a 99% probability that the actual return will lie within + / - three standard deviations from the mean.