Zaks Investment Advisory Service

Types of Financial Risk, and What to Do About Them

We started talking about risk in one of our previous programs, mentioning that there are several “types of risk.”

But for starters, let us answer one question: are there any types of securities that carry no risk at all? Yes, there are, and we have already mentioned them: these are Treasury bills, short-term debt paper issued by our government. They are guaranteed by the state, and while the state functions, these bills are guaranteed to be paid. But if it ceases to function properly…– then we will be facing other problems, far more serious than investment ones.

But jokes aside, why only Treasury bills? Does the government not guarantee its long-term bonds? Of course it does, and you may have no doubts about receiving your coupon and face value payments. But the problem is that the government is unable to guarantee you that interest rates will not change over the bond’s term, and these rates affect the bonds’ price. They also affect at which rates of return you are able to reinvest your coupons. When interest rates rise, rates on all bonds including ones issued by the government fall. We will discuss how this works and why some other time, but for now we will note that bonds are subject to so-called interest rate risk. What other types of risk are there?

The first and probably most important type of risk is called “investment risk.” This is the risk that, as a result of price fluctuations, your individual investment will lose a part of its value. We have noted on numerous occasions that prices on investments are never stable, and that they both rise and fall. For example, say that three months ago, you invested some money in the wonderful pharmaceutical company Pfizer, buying its shares at $27, and that now these cost $25. If you had to sell your shares now, you would lose about 7.5 percent of your capital. Of course, Pfizer shares have been known to grow at other times, but this does not improve your state of affairs one bit.

Let us take a look at what may be done to change this situation. As we have already mentioned, risk is determined by the spread, or variability, of returns over a particular period, and its value may be mathematically determined with the help of the so-called standard deviation. Imagine that you have a portfolio that is made up of two stocks. The price of each one jumps up and down, but not in a synchronized manner: sometimes the price of one goes up while the other goes down, and vice versa. In other words, there are situations (not always, of course) when the two prices balance each other out.

So, imagine that you bought not one company but two: you prefer pharmaceutical companies, so in addition to Pfizer you also purchased shares of Merck. Three months ago, these cost $41, and now – $44, i.e. about seven percent more. Thus, if instead of one stock, your portfolio consisted of two stocks of equal weight, then over the preceding three months it would have practically not lost any value. The variability of the rate of return of a portfolio consisting of two stocks was smaller than the return variability for each of the individual stocks (and the standard deviation rate of return of a two-stock portfolio is smaller than the standard deviation rate for each of the individual stocks). In other words, if you have two stocks that are not moving in unison and are not 100-percent correlated, then this portfolio is less risky than each of its comprising stocks. At the same time, and this is very important to note, the average long-term return of your portfolio is equal to the average annual return of the stocks that make it up. In other words, we lose nothing in terms of return, and gain from the fact that your portfolio becomes less risky.

Our investor likes pharmaceutical companies very much, and he bought two of them. Unfortunately for him, returns on pharmaceutical company stocks are highly correlated. For if he had purchased stocks from companies in other industries, stocks like Coca-Cola or IBM, the correlation between them would have been significantly smaller.

This simple fact rests at the foundation of the idea of diversification. In other words, why not try to create a portfolio in which shares cancel out each other’s individual risk? This idea of an “efficient portfolio,” i.e. a portfolio, in which the individual variability of the rate of return is neutralized as much as possible, led to the development of modern investment theory.

Even though this all sounds fairly complicated, for us, the most important point here is extremely simple: investment risk exists, and it may be reduced through diversification.

At the end of the 1990s, many inexperienced investors placed all of their money in shares of Internet companies, which at the time were rising like yeast. These investment portfolios were poorly diversified. When technology stocks went down, portfolios of these investors suffered far greater than those whose investments were well diversified.

One of the practical results of investment theory is the following very important fact: if risk may be diversified, the market will not reward it by an additional return. We know that usually, financial risk is rewarded through additional returns. However, if the risk may be eliminated, then the investor receives no additional return. What about your investments? Are they diversified? Your investment advisor could answer that question for you.

And with this, we will draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.