Investment Risks

OVERVIEW

There is a chance you do not earn the profit you predict, you may lose all your money, or you may end up needing more than expected. These risks come from many causes but apply to every investment you make, no matter how basic. In all cases investors demand compensation for assuming risk, or else everyone would invest only in ‘safe’ investments. That compensation is usually the expectation of higher returns. It can also be the reduction of another type of risk. It can also be the love of your family, when they need financial help.

You need not compute complicated equations or look up meaningless metrics, but you must explicitly recognize and heuristically evaluate all risks before you invest. Too often people simply ignore the possibility of bad outcomes that are obvious from the start. It is far better to assume the worst, rather than assume the best.

Money is always flowing between markets. The changing risk of one type of asset will effect the market prices (and risk premium) of other asset types. You must always evaluate the ‘relative’ attractiveness of an asset given its risk. An example of this effect was in 2008 when the economic risk of all businesses all around the world exploded in the ‘credit crunch’. The ‘flight to safety’ resulted in the price of US treasuries rising sharply, even though their own risk profile had not improved (and actually worsened).

Instead of working from an evaluation of risk toward determining the appropriate return, retail investors often reverse the process. They judge an investment by its expected return. They think large dividends and low P/E’s mean the investment is a good one. In fact, these metrics indicate the investment is NOT a good one; that there are some impending problems; that markets are demanding extra returns for assuming that risk.

The reason so many retail investors make that mistake is because it is far LESS WORK to find a widely quoted, single, objective number like the yield, than it is to properly research an investment. It should be, but isn’t, obvious that investing is far more difficult than ranking companies by one, single metric. If you do not want the bother of researching investments, please just admit it. You can buy index ETFs and do as well as the market, and probably better than all your stock picking friends.

For each of the following types of risks, you should understand their cause and effect; how they are measured; and how they are hedged.

REPAYMENT RISK (default risk, capital risk)

Most investments involve giving your money to someone else to do something with. You always run the risk that they abscond with your money, or that they go bust and cannot repay it. The US government is considered to have the lowest repayment risk, assuming they have the power to tax their subjects. Foreign governments are much more likely to default. They may even earn political points at home for doing so.

Businesses with majority owners pose the largest risk of default when things go wrong. The insiders will know, well ahead of public investors, when to start worrying. There are many, quite legal ways for them to recover their own money, leaving the company shell to the public. Once a business officially goes broke, laws determine who gets paid first. The tax man and employees rank high on this list. Debt holders come next, then Preferred Share owners. Equity owners come last, with the most risk of getting nothing.

Credit bureaus exist to measure the probability of default for specific debt securities. They cover bonds, debentures, preferred shares and income trust units. They usually have access to more information than the retail investor, so their ratings should be consulted. Be clear that they rate only the probability of default, not the risk of price volatility. A security may lose value temporarily because of market sentiment; sentiment that may not be correct in the longer term. As the ABCP crisis has shown, the rating agencies can be co-opted by the businesses whose products they rate, because they are paid by those same businesses. The rating of each security signals to the market what interest rate its issuer should pay. See this website for US bond spreads for each rating.

Regulators sometimes provide insurance to cover this risk. American (FDIC) and Canadian (CDIC) regulators insure cash in bank accounts (to a limit). Both countries have another plan to insure your securities held by brokerages. Note that this does not insure the value of those securities. It insures that the brokerage will not walk away with your ‘ownership certificates’.

Sometimes investors can buy insurance to protect their invested capital. E.g. real estate is frequently insured by owners. Its small cost is a good trade off against the value lost in a fire. ‘Counterparty risk’ refers to the risk that the party on the other side of the derivative trade (e.g. insurance) cannot pay the claims they contracted to cover. The insurance you buy, is only as good as the reliability of the insurer to pay claims. During the 2008 credit crisis, it turned out that institutions were buying insurance (credit default swaps) from companies that could not pay the claim.

Principal Protected Notes (PPN) are a product offered by banks and insurance companies that allow you to participate (to an extent) in the risky stock markets while your initial investment is guaranteed to be repaid in (say) five or ten years. You must weigh the cost of the insurance against the default risk. Say the PPN allows only a 50 percent participation in the market return.

• The cost of PPN’s insurance is the value of the stock returns you give up. If you think the stock market will return about 10%, then the insurance is costing you 5% each year.
• Contrast that against the probability that the stock market will have dropped after a
  5 year period (historically 11 times over 80 years) or
  10 year period (historically 2 times over 75 years).
  See the graph on Sheet 8 of this Excel file.

Another way to analyze the cost is to compare

• the return offered by T-bills with a US government guarantee (approximating inflation) to
• half the S&P;’s 5-year returns.

In 30 of the 42 5-year periods, the T-bill return was higher than 1/2 S&P;’s return. (Sheet 5 of the same Excel file).

PRICE VOLATILITY

When used by academics or finance industry people, the term ‘risk’ almost always refers to the volatility of the investment’s price. This is the sense in which the term ‘risk-reward tradeoff’ was coined. E.g. The yearly return from a US bond (safe) will fall within 8.3 percentage points above and below the average 4.8% return, 2/3 of the time. The yearly return from a US stock (risky) will fall within 19.9 percentage points above and below the average 10.1% return, 2/3 of the time.

Notice that the width of possible returns includes both the upside as well as the downside. Both are considered equally bad. Standard deviation is its mathematical measure. The math is based on a presumption that the probability of returns follow a ‘normal curve’. US equity returns show that kind of history. But other countries’ equity returns have had outlier results that are more extreme than predicted by a ‘normal curve’. They are said to have a ‘fat tail’.

Since investors demand a higher return for assuming risk the Sharpe ratio was devised as a measure of returns that have been normalize for volatility. The hedge fund industry uses this metric as a selling point. But the small sample size (short history) makes it mostly meaningless. It also ignores fat tails and assumes a ‘normal distribution’ of possible outcomes.

Volatility matters for two reasons.

1. Investors react emotionally to swings in market prices. It is emotionally hard to NOT sell an investment that has lost value. The result is an emotional toll, as well as a possible loss of returns from selling at the bottom. Buying a basket of different stocks/bonds allows the volatility of one’s upswing to offset the other’s downswing. In total your portfolio suffers less volatility and is easier, emotionally, to maintain. How many different securities you need to get rid of the individual security’s risk is not agreed, but it has increased recently. Some say you can reduce 90% of common equity’s volatility with 20 separate holdings. Of course you will still be left with the volatility inherent in the asset class itself.The measure of how closely a individual stock’s price tracks the price movements of the asset class is called the ‘beta coefficient’. The stock with a beta coefficient larger than one (or negative one) is riskier because its price swings wider than the asset class does. A negative beta coefficient means the asset’s price moves in the opposite direction to the market. A beta between one and negative one means the volatility is less than the asset class.Since investors demand extra returns for assuming risk, they should incorporate beta into the discount rate used to value a specific company. Say 10-yr T-bonds yield 5% and you demand 9% from equity investments. The equity risk premium would be (9% – 5% =) 4%. If a stock’s beta is (say) 1.3, then you derive a premium specific to the company equal to (4% * 1.3 =) 5.2%. The discount rate you would use equals the sum of the T-bond rate plus the specific equity risk premium (5% + 5.2% =) 10.2%. You can find a stock’s beta on the Yahoo Finance site in the “Key Statistics” link, on the right under the heading “Trading Info”. One way to benefit from volatility is called ‘dollar cost averaging’. When buying into any position, you can divvy-up the cash into equal-dollar, multiple purchases over time. The dollar value will buy more when the price is low, and less when the price is high. Your resulting cost-per-unit will be higher if the market price marches upward, because you delayed the purchases, but lower if the price declines or is merely volatile. The reality is that most people are enticed into the markets, or into a stock, after it has done well. In other words, they buy at the top (and sell at the bottom). Dollar-cost averaging will save you from this error.
2. Many investors have a need to liquidate the investment at a specific time – e.g. to pay for college in 2 years. It is impossible to know in advance whether the security will be at its high price at that time, or at its low price. If cashed out at it’s low point, that loss gets crystallized, permanently damaging the portfolio’s value.You can control this risk by choosing products with certain cash flow. E.g. A bond ladder is set up so there are sufficient bonds maturing in each year to fund a retiree’s draws. The investor does not fret about any price fluctuation during the bond’s life because it is irrelevant. The redemption value at the time it will be needed is know in advance. That is all that matters.The importance of this issue depends on your time frame. Price volatility decreases when you expand the time frame from one to twenty years. With longer time frames you ignore the price volatility in the interim. It is only the price and the beginning and end of the period that matters. This graph shows the US experience of volatility for different asset classes.This graph shows that stocks become LESS risky than bonds when the holding period approaches 20 years. This is because much of a stock’s yearly fluctuation is caused by business cycles. Periods of high growth are followed by recessions. Over 20 years these even out, or ‘revert to the mean’. Another reason is that investors pile into successful stocks and bid the price up beyond its true value. This will be followed by a correction that overshoots on the downside. Another reversion to the mean over longer periods. Of course there is an opposite academic point of view. The US experience is not universal. When international stock indexes are added to the data, there is no reversion to the mean, or reduction of risk over longer periods of time (Philippe Jorion).

ECONOMIC RISK

Market economies tend toward a cyclical boom/bust, as they correct, then overshoot, then correct again. Investors must know where they are in the cycle. They need to listen to the economists and central bankers and keep track of interest rates and inflation. This is required – sorry. Understanding business cycles and how they work is a prerequisite to effective saving and investing.

Business cycle theory says that as the economy heats up, business profits increase and their stocks rise. The reverse happens in the bond market. As companies borrow money to expand capacity they compete for capital, pushing up interest rates. When rates increase, the value of pre-existing bonds falls.

Unfortunately this negative correlation between debt and equity does not always hold true. For example, during the 1990’s corporate earnings and stock prices increased with global affluence. But interest rates never increased because savings from the developing world flowed in to finance the US expansion – keeping rates low.

Also, the expected negative correlation between debt and equity may not hold true in truly bad times. The value of bonds is usually impacted by market interest rate changes that provide investors with better/worse opportunities. But bond values also fall when the business’s ability to repay the principal becomes questionable. In bad times when profits and stocks are falling, the debt may also fall in value due to insolvency worries … in spite of the government cutting interest rates.

Never-the-less, some assets gain value in a booming economy (equity). Others gain value in economic contractions (debt). Some assets rise in value with inflation (real estate supposedly, and commodities). Other assets lose value with unexpected inflation (debt, utilities). Investors can reduce the risk of being whipsawed by business cycles by holding different asset classes. This is called ‘asset allocation’.

The correlation between the returns of different asset classes is measured by the correlation coefficient for each pair. A coefficient of 1 (one) means that an x% increase in class A will happen at the same time as the same x% increase in class B. A coefficient of <1> (negative one) means that class B will fall by the same x%. Most asset classes fall between these extremes. Asset allocation is still worthwhile, even when posatively correlated, because different classes with have higher returns in different years, thereby smoothing portfolio returns.

Advisors will have you think that the asset allocation decision will make or break your investing success. But as you can see from this list of risks, asset allocation is just one of many risks you have to manage. If you care to read this, here is the seminal academic paper on Portfolio Selection by Markowitz (1959)

‘Diversification’ is the term used for buying baskets of securities within each asset class. It reduces the risk of individual investments the same way ‘asset allocation’ reduces the risk of single asset classes. Your total return is a blend of each component’s return. It is easier to ignore the price swings of one investment if the portfolio, in total, has steady values.

• You allocate between asset classes to reduce the volatility of business cycles. In spite of cycling, the global trend is up. So you hold all asset classes for the long term, through the troughs.
• You diversify between countries for exposure to different types of economies. E.g. Russia is tied to oil, and Japan to manufacturing. View these series of 60 year graphs of stock returns from different countries. Also read this paper on comparative returns from country diversification. See also ‘Political Risk’ below.
• You diversify between industry sectors because they rotate in importance to the economy. E.g. Technology was hot in 1999 and Commodities were hot in the 2006.
  
• You diversify between companies because they compete. Some will be winners: others losers. For a disheartening study read this summary. Then read this more optimistic summary.

People living and working in one-industry towns should consider NOT owning real estate in order to allocate risk away from the same economic exposure of their job. For the same reason, holding stock in the company you work for increases your risk. Asset allocation won’t accomplish much if all your assets are based on the fortunes of one company.

Most all investors are sorely tempted to ‘time the market’, i.e. to rotate their ownership of asset classes through the business cycle. We all think we can avoid losses by (e.g.) selling equity and buying bonds at the peak of the cycle. The research shows that we cannot do this consistently well. Sometimes we do not recognize the inflection point. Other times the economy is not working like a theoretical business cycle. E.g. the 2000 tech bubble was not a business cycle event: there was no contraint from limited capacity at its peak. E.g the 2008 liquidity crunch was not a business cycle event, although it caused a business recession. Theoretically we should just set the asset allocation and hold. But the urge to meddle is very strong.

There are problems with asset allocation and diversification.

• Costs can increase. Some asset classes have transaction costs much higher than for simple company stocks, for example real estate. Some require much more intensive management, for example private equity. See Sheet 15 of this spreadsheet for the effects of rebalancing transaction costs for debt.
• The size of some asset classes is small. When large numbers of investors pile in/out, their decisions cause prices to whipsaw. Liquidity is necessary for efficient trading. However, the long-term buy-and-hold investor will be impacted less.
• The different classes may be driven by the same economic factors. For example all risky assets will increase in value when interest rates are low and the economy is growing. A well-known adage is “In a crisis everything correlates”. For example recently, the equity markets in all developed countries have been perfectly correlated. The graph below is quite different from the divergent, uncorrelated historical returns.

INTEREST RATE RISK

Changes to market interest rates impact the value of most investments. Think of interest rates as a proxy for the discount rate you use to value investments. When you demand a greater return, you pay less for the security, and vice versa. So when interest rates go up, the value of most investments goes down.

One bond metric is its “duration”. This measures its price-sensitivity to changes in interest rates. Duration is calculated by weighting the cash flows from a debt security by their timing. (See examples of calculations). It’s interpretation is roughly: “duration equals the expected percent change in value of the security that will result from a 1% change in the market interest rates”. E.g. A bond with duration = 4 may be expected to increase in value 4% if market interest rates drop 1%.

Duration reflects how far out into the future the cash flows are. A change in interest rates has a larger impact on cash flows farther into the future because the effect gets compounded for each year. When comparing two securities with the same maturity, the one with the smaller distribution (e.g. a strip bond) will have a larger duration than the high-yield bond. When comparing two securities with the same current yield, the one with the longer maturity (e.g. a perpetual preferred share) will have a larger duration than one with a short maturity.

The return you demand for any security is grounded in the other investment opportunities you have. You always have a choice. All returns are grounded in the interest rate you ‘could have got’ from a safe government debt. This concept is called your ‘opportunity cost’.

Overnight bank rates may change because a central bank decides so, or the longer term rates may change because market participants bid up/down the value of debt. Normally a change in short rates gets reflected in the longer rates. An increase in the short rate will make all longer rates less attractive because the premium for that term risk has been reduced. So the resale value of the long debt will fall. See the discussion of the yield curve under term risk below.

A product that hedges interest rate risk is the floating-rate debentures. These pay interest at rates that vary with the Prime Rate. As long as the coupon reflects current market yields, the security will not lose value due to interest rate risk.

It is not just debt that loses value when interest rates rise. The equity of utility companies will also lose value. Their high dividends are a proxy for interest payments. But the companies cannot raise them because most all their profit is already being paid out. The companies’ profit and prices are set by regulators. Owning common stock of active businesses is your best hedge. You want companies with the pricing power to adjust to changing interest rates.

RELATIONSHIP BETWEEN INTEREST RATES TO INFLATION

Often there is a direct correlation between changes in interest rates and inflation. The theory of a business cycle says that as an economy heats up:

• Production increases and greater demand for parts and supplies drives up these prices.
• The increased input costs get passed to consumers with higher resale prices.
• Companies use all their existing capacity until more capacity is needed. To finance the construction of that new capacity businesses borrow. The increased competition for borrowing drives up the interest rate businesses are willing to pay.
• At the same time, the central banks do not want big booms and busts so they try to damp economic swings. They raise interest rates with the objective of making that new capacity more expensive and less likely to be built.

But that theory of a business cycle does not always happen as advertised. For example, the double-digit inflation of the 1970’s was caused by banks keeping interest rates low in an attempt to stimulate a weak economy, at a time when imported inflation from the oil shock was high. Then, in the 1980’s interest rates stayed high even while inflation fell because of investors fear of inflation.

So hedging investments for interest rate risk will not always hedge away the inflation risk. One way to hedge both risks is to buy only short-term debt. That way you continually roll over to new debt issued at new interest rates that reflect current thinking about inflation. The trade-off though, is the lower return you earn on these products.

INFLATION RISK

Remember that savings are ‘deferred gratification’. The only reason you don’t spend your money now, is because you expect to have a greater purchasing power later. So savers always demand that investments provide a return that will cover, AT THE LEAST, the loss of purchasing power caused by inflation. Interest rates on debt will be higher when high inflation is expected. P/E multiples on stocks will be lower when higher inflation is expected. (Because the flip side of P/E is E/P – the earnings yield).

Academics love to measure everything in “real” returns. They consider it a loss if the returns are not greater than inflation. But investing results are not highly correlated to inflation (Sheet 17 of this spreadsheet.) So it is more informative when returns and inflation are measured separately.

‘Expected’ inflation is not the risk. The risk lies in the actual inflation turning out to be different from that expected at the start. E.g. The Yield-to-maturity at which you buy a bond will always factor-in the inflation expected during the bond’s future. But your expectations may not pan out. Buyers of US T-Bonds in 1962 realized 5-yr, 10-yr, and 20-yr returns that were lower than inflation – negative real returns (‘real’ returns are the excess of nominal return over inflation).

Debt with longer terms have more inflation risk, because the inflation 5 years from now is harder to predict than tomorrow’s. Plus, any error in the expectation will be compounded over a longer time – exacerbating the error. So 30-year bonds have more inflation risk than 30-day T-bills. (This is included in the concept of ‘term risk’).

HEDGES

1. One way to hedge against unexpected inflation is to buy Government debt whose value is adjusted each month by the Consumer Price Index of inflation. In the US these are called TIPS. In Canada they are called Real Return Bonds. See this Excel sheet’s graph. There are three problems.
   • You must accept that the government’s measure of inflation is correct. There are many people that do not agree with their methodology. If you think the CPI understates inflation, then your returns will also underperform.
   • The second problem is caused by the market’s valuation of the product. The only people buying this product are explicitly afraid of inflation. Their estimate of future inflation, and the risk attacked to that estimate, will be higher than the same estimates by people buying regular bonds. Technically, the difference between the regular bond’s yield and the inflation bond’s coupon equals the inflation expectation. But this difference in perception means RRBonds may be overpriced compared to regular bond.
   • There are tax issues to consider. Each month the principal is revalued by the rate of inflation. This increase will not be recovered until you sell the bond, yet it is taxable today. That results in a cash-flow mismatch. Try to hold these bonds within tax-protected accounts.
2. Another way to hedge inflation is to buy equity shares of businesses that can pass their rising costs along to their customers. While it is true that equity returns, in the short term, do not increase with inflation, over longer periods companies catch up with their pricing. There is a reversion to their mean ‘real’ profitability. The same cannot be said for debt. Unexpected inflation will cause reductions in ‘real’ returns from which there is no subsequent recovery. Debt returns have no reversion to the mean.
3. It is said that buying gold and commodities is a hedge for inflation. But over long periods their returns are lower than even inflation. These products do not ‘grow’ because they have no profits to reinvest. They have a market value that rises and falls, but no consistent up-trend. Compare that to a business whose stock also rises and falls, but whose value increases in the long-term because profits are reinvested and the economy grows.
4. Products whose payouts are prearranged to increase from year to year do NOT hedge inflation. These include annuities and GIC’s. Remember that ‘risk’ is in the unknown future differing from the expected. Any increase that is pre-set will not, by definition, reflect the actual inflation.
5. Media advice says: “owning debt protects you from deflation and owning real estate protects you from inflation”. But neither is a valid argument.
   • Inflation/deflation do not cause any investing problems, when correctly predicted. The loss/gain of purchasing power is recovered through interest payments. Risk pertains only to the unknown – the difference between the expected and actual.
   • Debt owners benefit from inflation being lower than expected, not deflation.
   • Deflation has almost never existed outside Japan and the 1930s depression. So do you need protection from it?
   • Real estate does NOT keep up with rapid inflation. See the discussion on capital gains on real estate and the graphs at the bottom of that page.
6. Although not a hedge, high-yield corporate debt will be impacted less from inflation changes that will low-risk government debt. This is because more of their yield is on account of their risk premium, on top of inflation.

LIQUIDITY RISK

The liquidity of an investment refers to:

• how fast it can be bought/sold
• how high the transaction costs are
• the balance and quantity of buyers and sellers in the market so that big volumes won’t ‘move the market’.

Real estate is very illiquid. It takes months to close the deal; and lawyers, agents, appraisers, taxes and movers can cost almost 10%. In contrast, purchasing a stock takes seconds, cost about $5 and has millions of players making the market.

The importance of this risk depends on the individual investor. E.g. pension funds have stock positions worth millions of dollars. They have a hard time buying/selling a position because of this size. There are not enough buyers on the other side of the transaction. In contrast, small retail investors can invest in penny stock with very low volumes. Because their holding are so small they will not move prices.

The importance of transaction costs is related to the frequency of trading. Real estate is usually held 5-7 years, so the higher commissions are more palatable. In contrast, stock brokerages that earn revenue from trading fees, drop their per-trade commissions because that encourages a much higher frequency of trades.

TERM RISK

Investors require higher returns when they commit their money for a longer period of time. We can only guess the future. The farther into that future the harder to predict. A company that is perfectly healthy today, may go bust in five years. Inflation ten years from now is harder to predict than tomorrow’s. Your own needs for cash become harder to predict over longer periods. Maybe you will be dead before that bond matures.

Bond holders measure this risk two ways.

1. A yield curve refers to a chart that plots the market returns required for debt of different maturities. A ‘normal’ curve will rise as the term gets longer. Interest rates for long-bonds are higher than for T-bills. See also this more detailed account of the yield curve.
2. “Payback period” measures the number of years before all the cash flows from the debt exceed the original investment – when you have recovered your cost, but earned no return. The longer the payback period, the more risky. E.g. a mortgage is less risky to own than a bond. The bond pays only interest until maturity, but the mortgage’s payments include a portion of the principal as well. This metric also shows up in the stock analysts’ “Debt to EBITDA” ratio. EBITDA is a proxy for the cash available to pay back the debt. The ratio equals a theoretical payback period.

Preferred shares are issued with different attributes. Some have a specific redemption date and are more similar to bonds. Perpetual preferreds never mature and so are much riskier. Common stocks have no redemption rights so they are most risky.

REINVESTMENT RISK

This risk applies to both the reinvestment of principal at the end of the investment and also the reinvestment of the income paid out along the way. The problem is that the rate of return to be earned on the next investment is unknown at the start of the first investment.

Consider having to choose between (A) a 2-year investment earning 10%, and (B) a 1-year investment earning 12%. While it is clear that (B) is the better choice if only the first year is considered, it is unclear what opportunities will be available in a year’s time for reinvestment. If you cannot find anything offering at least 8%, at that point, then (A) would have been the better choice. The point is that you don’t know … you face reinvestment risk.

You must trade off “Reinvestment Risk” against “Term Risk” (as discussed above, the investment that returns your money faster is less risky than one paying out only at the end of the term). Term risk refers to the risk of default; the risk that the solvency of the borrower will have deteriorated; the risk that market conditions will have changed. In truth, recovering cash early is really a double edged sword. Those payments during the term of an investment must be put to work on their own account. At the start there is no way to know what rate of return they will earn. An example of this is the escalating rate GIC. The surety of automatic reinvested interest is preferable from this point of view.

This same risk is called “Pre-payment Risk” in the context of mortgage-backed securities. Some mortgage products allow borrowers to pay off their debt early. Borrowers will do that when market interest rates fall and they can get replacement mortgages at lower rates. That leaves the investor with cash to reinvest at those same low rates. While he might have expected to earn 8% for 10 years, all of a sudden the investment ends after 2 years, and his only options are to reinvest at 5%.

The math for calculating the Internal Rate of Return (IRR) or Compound Annual Growth Rate (CAGR) presumes that the reinvestment rate is the same as the original investment’s rate of return. But in many cases that presumption is wrong. People with finance education will understand that this problem (the presumptions in the math) can be overcome by analyzing investments using Net Present Value (NPV). But this is too difficult for beginners to learn.

FOREIGN CURRENCY (FX) RISK

In order to reduce economic risk you are told to diversify investments internationally. But that process exposes you to changes in the exchange rates of foreign currencies. Another double edged sword. A foreign investment is worth less to you after its currency weakens, and vice versa. FX risk can be hedged to a great extent. See the detailed discussion at Hedge FX

POLITICAL RISK

One of the reasons investors tend to invest most of their money at home (home country bias) is because they feel comfortable with their knowledge of the political climate. Generally speaking investments are safer in democratic/capitalistic societies. But all governments can

• confiscate property
• impose tariffs and taxes
• regulate costly environmental compliance
• go to war and blockade access
• even bail out investors (from a loss) when enough political pressure is applied.

But business now is international. Business leaders must play the political game and make risk/return assessments. The only thing you can do is either demand higher returns for investments in riskier countries, or stay away completely. Standard and Poors provides ratings of sovereign countries you can use, also the Economist Intelligence Unit. The Belgian Export Credit Agency also publishes ratings.

FINANCIAL VS. OPERATING RISK

These terms are most used from a business’ point of view. They do not pertain to passive investments. But the investor can make active investments too (e.g. buying a rental property). The two terms distinguish between the same two types of effects that the Income Statement tries to distinguish. Operating risk refers to the business’ operating profit. Financial risk pertains to the financing obligations of the business. E.g. for a landlord;

• There may be delays in finding a tenant, so the empty property generates no revenues, destroying his operating profit.
• If he must renew his mortgage at a higher interest rate, the extra interest may destroy his Net Income.
• If he withdraws equity (borrows a greater percent of the investment’s cost) he must deal with the magnifying effects of leverage.

Even if your investment is not in a project or operating business, you are still exposed to these same risks that are within the companies whose stock and bonds you buy. Their risks are your risks. But this issue is better covered under the discussions of company analysis . See also Math for Leverage.

LONGEVITY RISK

Retired people living off their principal as well as income, risk running out of money before they die. This may be because

1. investment returns were less than expected,
2. they made such a poor investment that they lost the principal (on top of the income),
3. their investment returns were more variable than expected so that yearly withdrawals had a bigger negative effect,
4. inflation was higher than expected (and returns did not compensate),
5. they lived longer than expected (longevity risk), or
6. they spent more money (in real dollars) than expected.

There are two ways to offset these risks.

1. Members of a Defined Benefit Pension Plan (DBPP) that is indexed to inflation are hugely lucky. Not only is the investing risk and work assumed by others, but members benefit from the deaths of their cohort (splitting the pot between fewer beneficiaries). And the best part – longevity risk is completely taken care of.
2. People without a DBPP can purchase annuities (NOT variable annuities) from insurance companies. These pay out a specified amount until death. The payments can be stable, or increasing by a specified rate, or indexed to inflation. They can start immediately or at a later date.

CREDIT RISK

Most business sales are not paid for at the time. The seller ‘invests’ in his client by accepting debt. The seller faces

• the risk of never being paid (repayment risk)
• not knowing when he will be paid (term risk) and
• not knowing how much it will cost him to collect (liquidity risk).

One solution is to sell the investment. Businesses known as ‘Accounts Receivable Factors’ will buy baskets of receivable and collect the money themselves. Of course the amount they are willing to pay for the basket is discounted for their anticipated costs and additional profit.