Zaks Investment Advisory Service

More about Types of Financial Risk, and What to Do About Them

Last time we mentioned that there are several “types of financial risk.” We stopped at investment risk, and said that it may largely be eliminated with the help of diversification.

But it is impossible to completely escape risk through diversification because there is also such a thing as “market risk.” This is usually what people refer to when they talk about the risk of stock market investments. Imagine that the entire market (whether it is the stock or bond market) goes down. If your portfolio were made up only of stocks or only of bonds, then no matter how much you tried to diversify, you would still not be able to avoid a loss. Theoretically, there are ways to protect your investments in such a situation through futures and options, employing the strategy of so-called portfolio insurance. Unfortunately, these do not always work. For example, this strategy could not save investors on Black Monday, October 19, 1987, when the market lost about 20 percent in a day. (Why it did not work is a subject for a separate program, as is the story of Black Monday.) In addition, during a period of a prolonged market decline (a so-called “bear market”), portfolio insurance is also of no help. Recently, one such period stretched from mid-2000 to about the middle of 2002. Thus, market risk exists and is inescapable. However, at least it is rewarded by a return. I would like to add that the financial market only “rewards” a return on risk that may not be avoided, one like the market risk. On the other hand, investment risk, which we discussed in our last program, and which may be averted through a diversification of the securities portfolio, is not rewarded by an additional investment return. So, if your portfolio is poorly diversified, then you assume risk “for nothing.”

Another type of risk that we already mentioned in the previous program is called “interest rate risk.” A rise in interest rates leads to a fall in the price of bonds. It also, but to a lesser extent, has a negative effect on stock prices. On the other hand, people who live off of fixed interest payments (for example, the interest paid by banks on savings accounts and certificates of deposit, which increase with the general rise in interest rates) only stand to benefit. Unfortunately, high interest rates are also usually accompanied by high inflation, so as a result we all suffer from them, even those of us who earn bigger interest returns on their fixed investments. Usually, when interest rates go up, prices on long-term bonds, i.e. bonds that will be paying coupons for many more years and whose maturity date is still a long way off, drop more severely than on short-term bonds – whose maturity date is near. By the way, I would like to note that despite the fact that our central bank, the Federal Reserve, has recently been raising the short-term interest rates, we are currently living in a period of relatively low interest rates. In the early 1980s, the rates on long government bonds were almost 14 percent. Right now, they stand around five percent. They were above 14 percent on the three-month Treasury bill, whereas now it is below five percent.

Inflation risk is closely related to interest rate risk (when inflation flares up, interest rates also go up; the opposite is not always the case: sometimes, interest rates go up even though inflations stays put). Inflation risk is especially dangerous for bonds. The thing is that bonds pay coupons whose price does not vary over the term of the bond – for example, a 6% 10-year bond pays $30 on a bond with a face (or nominal) value of $1,000, paid twice a year for 10 years. During a time of high inflation, the present value of the coupons, which will be paid out in the future, and the face value of the bond, which will be paid when it matures, both drop. We will talk separately about the present value of future payments, as well as about how the price of bonds is determined, since these are pretty important things. But even without that analysis, it is clear to us that money becomes “cheaper” during inflation, and that $1,000 in the future costs less than $1,000 in current money – especially if inflation is high. By the way, inflation, too, is relatively low right now: inflation has been under three percent in recent years, according to the consumer price index (CPI), while the “core” inflation, which excludes the price of foods and energy goods because these are not constant and change from month to month, has been around 2.4 percent. Of course, there are no guarantees that it will stay this low, and this uncertainty creates “inflation risk.” You have probably heard that inflation has recently grown slightly, and that this has concerned the Federal Reserve. Ben Bernanke, the new Federal Reserve chairman, has recently been making statements making it clearly that he is quite worried about a rise in inflation, and that he will fight it if necessary by raising interest rates. So the question comes up: can investors protect themselves from inflation risk? Yes, through a stock portfolio: stocks are not as subject to inflation risk as bonds are. We will learn why this is the case in another program.

I would like to mention that there are several other types of risk: credit risk, or the risk of bankruptcy (we will discuss this when talking about bonds); currency risk (will discuss it in connection with investments in foreign markets); the liquidity risk (i.e. the risk that we will be unable to find buyers at the moment we want to sell a certain security – by the way, this risk affects all property holders); and certain other types of risk that we will discuss together with the financial instruments which are affected by that type of risk .

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