Investment Risk in Detail

by | Feb 24, 2017 | Risk

Today we begin to look at investment risk in greater detail.

This expands on our preliminary discussion in Defining Investment Risk.

Investment Risk Revisited

Previously we defined investment risk as a speculative risk. As such, investment risks provide the possibility of incurring a loss, breaking even, or profiting. This differs from pure risks where you cannot profit from the risk.

I wrote that investment risk is the probability that the actual returns on an investment will differ from the expected returns. The higher the probability of a different result, the greater the risk. The lower the probability of a different result (or the greater the certainty of the same result), the lower the risk.

That may mean a loss like with a pure risk. A gain, but less than was expected. Or it could mean a bigger return than anticipated. So a risk, yes. But one that may bring rewards.

Investment risk is simply the level of volatility of returns. Not a risk of loss. Important to remember.

Investment Risk in a Graph

For those of you poor souls who have taken statistics courses, investment risk is typically viewed from a normal distribution perspective. The graph below is an example of a normal distribution curve.

marzano2001a_fig1-1

Not the easiest concept to explain in a blog post (augmented by the fact that I am not a statistics professor), so we shall try and keep this basic.

Outside of a few key concepts, I intend to keep the statistics and formulae at a minimum. Not fun to read, nor usually necessary to understand the principles. But I think it worthwhile for risk as it is calculated via standard deviations.

Like head-ache medication though, I caution you not to read this post while driving or operating heavy equipment. The following may just put you to sleep.

Normal Distribution

You may also recognize the graph above as a Bell curve, so named for its shape. Or you may have heard it called a Gaussian distribution; named after Carl Friedrich Gauss.

Within a normal distribution, historic outcomes are placed on the graph and a distribution similar to the one above typically results.

The “Y” axis represents the actual outcomes. The more results at a certain level, the higher the curve. The bottom “X” axis represents the distance from the average (i.e. mean) result.

It is called normal because the outcomes are symmetric in nature. You can see this by the equal spread of outcomes on both sides of the curve. Note how the tails on both the left and right sides of the curve are similar in distribution.

If the distribution was not normal, but rather skewed, one end of the curve would be longer and more pronounced than the other end.

The important thing to note with a normal distribution is the way the Bell curve looks. Most of the actual results cluster relatively close to the middle of graph. The higher the curve, the more results are at that level. As you move farther from the middle, the number of results decreases. This creates the diminishing tails at either end.

In the real world, normal distributions are common. For example, the average height of US men is 5’10”. Most American men are  roughly this height. The proportion taller or shorter will continue to diminish as you move away from this average.

And it should make sense that the larger the sample size, the more appropriate the results. If you sample 3 men, you may not find an average of 5’10”. If you sample 300,000, you will get a realistic average. The same holds true with investing. The smaller the sample size or time period, the more questionable the result.

Mean

In investing, the mean is the expected return on the investment. This is represented by the average result on the above normal distribution curve, located at position 0.

The expected return may be calculated based on historical data, theoretical probability models, experience, and professional judgement. Perhaps the expected return will be 2%, 12%, 22%, etc. The 0 midpoint on the Bell curve simply represents the consensus expected return.

As most investments carry risk, actual results may differ from expected outcomes. Actual results usually lie somewhere to the left or right of the expected return. That said, there is no reason that they cannot fall exactly on the mean.

Note that you may encounter “median” as an average. It is not. A median return is one that simply takes all values, sorts them in ascending order, and determines the middle value. For example, you have 5 returns. 3, 4, 5, 16, 22. Median just puts the numbers in order and finds the midpoint. In this example, 5. There are 2 outcomes to the left, 2 to the right.

Calculating the arithmetic mean, you add up all the values and divide by the number of outcomes. In this example, the arithmetic mean is 10. Significantly different than the median.

And no, do not use median to assess investments. Median has some value, but use mean if possible.

Note that arithmetic means often have their own flaws. We will explore those and the use of geometric means later.

Investment Risk

So we know that the expected return of an investment is the mean, or average, in a normal distribution. We also know that the actual results will fall on either side of the mean.

But what does that tell us about the investment risk?

The investment risk is the variability of the actual returns around the mean. In English, simply how far away from the average return is the actual result. The average is 0, the high point on curve.

As you can see above, actual results may be both greater or less than the expected return. So investment risk applies to the possibility of higher than expected returns, not simply lower than expected ones. However, investors are usually more concerned with results to the left of the curve. That is, where the actual performance is less than the expected returns.

The risk of an investment is determined by the variability, also known as volatility, of the actual returns around the expected return. Volatility is the amount of fluctuation in the actual returns from the expected returns. The greater the degree of volatility, the greater the risk of the investment.

The tighter the probability distribution of the expected future returns around the mean, the greater the certainty of the returns. As the certainty of the return increases (i.e. the less potential difference between the actual and expected result), the smaller the amount of uncertainty or risk. In a normal distribution curve, the vast majority of actual results would amass extremely close to the mean. The bell would be quite high and narrow in width.

For results with high variability, the actual returns would be disbursed much farther from the mean. This would cause the bell shape to be shorter in height and much wider in width.

An Example of Investment Risk

For example, investment “A” has an expected return of 5% and the actual returns over the last 6 years were 4%, 6%, 5%, 5%, 6%, 4%. The distribution around the 5% mean is quite tight. You would be right to expect the return over the next year to be close to the expected outcome. The risk that the return will not be close to 5% is low.

Investment “B” also has an expected return of 5%. However, its performance for the last 6 years was 2%, 12%, -4%, 15%, -3%, 8%. The actual results are significantly different from the expected result. You should be concerned that the actual result for the upcoming year will not be close to the expected return of 5%.

Here you have two investments with the same expected return. Yet the certainty of earning 5% on A is pretty high for next year while there is very little guarantee as to what B returns. It may be 5%. Or it may be significantly different than 5%. Even experiencing a loss. A’s expected future return is pretty certain. B’s expected return will be very volatile.

That is investment risk.

So how does one differentiate between the two investments?

Defining Investment Risk

by | Feb 20, 2017 | Risk

What is investment risk?

Investment risk is a form of speculative risk. Speculative risks differ from pure risks in that with a speculative risk there is a possibility of gain, not just loss or no change in status.

But what does that mean?

Is Investing a Gamble?

Gambling, like investing, is a speculative risk.

Perhaps you play poker with friends monthly. Sometimes you lose, occasionally you win, and a few times you may break even. But when the evening begins you do not know what the outcome will be.

Some authors claim the opposite is also true. That speculative risks are merely gambles. By extension, investing then must also be a gamble.

I do not agree with that viewpoint. Here are a couple of reasons why.

Beating the Odds

First, when visiting Las Vegas, there are steps that can be taken to improve your probability of success. You can study effective gambling strategies; avoid alcohol, emotional swings and sleep deprivation; only play games with the best odds.

However, there is a reason that Las Vegas is profitable. The odds are always in the house’s favour. In the short run one may profit. But over the long haul the probability of loss is certain for gamblers.

You can also improve your probability of success in investing. Education and experience will help you become a better investor. Taking a disciplined approach that eschews emotion from decision-making (or as Alan Greenspan would say, avoiding “irrational exuberance”) will also improve your chance of success. You may decide to only invest in assets with the “best odds” as well.

Despite media stories, the markets are not a casino. Investments are not games of chance that were expressly created to provide the casino with a built in advantage. Learning to properly invest is not simple, but it is possible to “beat the house” over the long run.

Potential Certainty of Returns

Secondly, when you enter the casino with $1000 you have no idea what you will leave with at night’s end. Depending on your luck and skill, you could win $1 million, break-even, or (more likely) go home with nothing except a few free drinks and a shrimp cocktail for your efforts. And that is not factoring in a possible trip or two to the conveniently located Automated Teller Machines.

Again, investing is different. I can list numerous investments where the outcome is known with (almost) 100% certainty. If you invest $1000 in a 1 year 5% Guaranteed Investment Certificate offered by your bank, at the end of the term you will receive $1050. Or you could invest $975.90 in a 6 month US Treasury Bill (T-Bill) yielding 5% and be confident of receiving $1000 upon maturity. Unless your bank or the US government defaults on their debts, your investment is completely safe.

While it is fair to say that investment risk is not gambling type risk, what is it then?

Investment Risk Differs Between Individuals

Investment risk is difficult to pin down. It is a concept that differs from individual to individual. What I think is risky may not be to someone else. And vice-versa. One’s personality, experiences, and personal circumstances all contribute to how a person perceives risk.

The World of Dickens

On one end of the traditional risk spectrum is the stereotypical widow or orphan. Not the ones with the enormous trust funds, but those from the world of Charles Dickens.

This group has very little money to begin with so preservation of capital is paramount. They invest in the hope of generating enough positive cash flow to buy their daily gruel. If you ask them about risk, they will say anything that could possibly reduce their original capital is risky.

The widow would definitely not want to double down at the blackjack table. She would also be uncomfortable investing in common stocks, corporate bonds, or real estate; investments with any uncertainty in repayment of the original capital.

This investor is only interested in guaranteed investments where her money is secure.

Versus the Wolves of Wall Street

On the other end of the risk spectrum is the hot shot young Wall Street finance expert.

If you ask about risk, you will get a long convoluted response that probably makes little, if any, sense. One involving the Greek alphabet (Alpha, Beta), strange acronyms (CAPM, SML), fun mathematical expressions (normal distributions, variability of returns, standard deviations), and crazy men (Sharpe, Treynor).

Like the lyrics from a pop song, the phrase “variability of returns” would endlessly echo in your head.

At the end of the explanation, you would probably back slowly from the room, grab a stiff drink, and return to the widows and orphans. At least they made some sense.

While the concept of investment risk is unique to each person, may I suggest that the average investor take a view somewhere in between Dickensian widows and Wolf of Wall Street financial experts. Closer to the expert’s view of the world would be my recommendation, but each person must be comfortable with their own risk profile. If not, there will be many sleepless nights filled with angst and Pepto-Bismol for your growing ulcer.

Investment Risk Defined

In looking at risk from the middle of the spectrum, investment risk is simply the probability that the actual return on an investment will be different than the expected return.

The greater the probability that the returns will differ, the greater the risk. The greater the certainty that the expected result will actually transpire, the lesser the risk. This is where the phrase “variability of returns” arises and we will look at it in detail later.

Sounds complicated. But when we get through our discussion of risk and returns, you will see it is not that bad.

A Simple Example

Let us use a simple example. If you invest $975.90 in a 6 month, 5% US T-Bill you will receive $1000.00 at maturity. The US government issues and guarantees payment on T-Bills. Unless you believe that the US government will default on their debts you are certain to receive the full amount.

In terms of the above definition, the probability that the actual return of capital ($1000.00) will be different than the expected return ($1000.00) is zero. The actual and expected returns ($24.10) are identical. You know the actual outcome with 100% certainty.

You expect to receive $1000. You actually receive exactly what you expected. Zero risk as actual equals expected.

For this reason the interest rate offered on short term US T-Bills is commonly considered the risk-free rate of return. There is no risk that the expected and actual returns will be different. The investment itself is considered to be risk-free.

Note this assumes that governments pay their debts. This assumption keeps eroding over time.

What about a common share of ABC Inc? The current share price is $9.76. Professional analysts agree, on average, that the price should increase to $11 at the end of 6 months. By investing $975.90 into ABC and not US T-Bills, you expect to receive $1100.00 after 6 months. An improvement from the $1000.00 you would receive from the T-Bill investment.

You invest your money into ABC shares, then promptly fly to Peru to spend the 6 months studying Incan civilization in the Andes. Far from wi-fi or cell phone connectivity. But thinking about that extra profit you are earning.

At the end of the 6 months you return home and go to sell the shares, fully expecting to enjoy that extra $100 in profit. Imagine your surprise when you find that the share price is now trading at $9.00 and you have actually lost money on the transaction. In this case the expected return ($1100.00) was significantly different than the actual return ($900.00). That is the impact of investment risk.

You expect to receive $1100. You actually receive a different amount than you expected. The fact that you did not receive exactly as expected represents the riskiness of the investment.

Note that it has nothing to do with receiving less ($900) than you expected ($1100) or initially invested ($976). Had you received $1500, it is still different than what you expected, so still represents risk.

The investment risk is simply the difference between what you expected to receive versus what you actually received.

Note that the higher the investment risk (measured by standard deviation), the greater chance the actual return will differ from the expected in higher levels. Hence the use of the term “volatility” for investment risk. Greater the risk, the more volatile the asset. The less risk, the more stable the expected returns will be over time.

This is also quite a real example. If any of you have ever invested in a stock based on analysts’ recommendations and/or price estimates, you will understand the percentage time they hit the mark. Seldom if ever.

We will review the relationship between risk and return in detail as it is critical to understanding the investment process.

For today though, I ask you to think about the following scenario.

How Do You View Investment Risk?

You have $1000.00 to invest and two options are available. Unless stated otherwise, we will always ignore costs in simple examples (e.g. transaction costs, taxes, management fees). Something never to ignore in real life.

You can invest in a 1 year US Government Bond yielding 5%. At the end of the term you will receive $1050.00 with 100% certainty.

Or you can invest in ABC, trading at $10 per share. Expert consensus is that the share price will rise to $10.50 in 1 year. This will provide the same expected 5% return as with the US Government Bond.

But ABC is not the US government. Also, other factors may be at play that impact the certainty of the price forecasts. The probability of actually receiving the expected return is less than 100%. You may receive more, you may receive less. It is impossible to predict with certainty.

Which would you choose for your investment? Many investors would choose the more certain return. Especially given that the expected returns are identical.

Investing 101

That tends to be an investment axiom.

If two investments offer identical expected returns, investors normally choose the lower risk asset. Conversely, if two investments offer the same level of risk, then investors will choose the asset with the higher expected return.

Investor Specific Risk Tolerance

But what if the experts’ consensus on ABC increased to $12 per share in a year? Does the higher potential return make up for the greater risk of ABC versus the US bond?

If not, how about a consensus price of $14 in one year? Or perhaps $16? What about if the consensus is only $8?

At what price point does the higher risk of ABC versus the risk-free bond make it a worthwhile gamble/investment?

What if there was no average consensus? Rather, there is a 25% probability the stock falls to $8, a 25% probability that it rises to $16, and a 50% probability that it rises to $12?

Does this new scenario change your investment decision?

How you answer these questions helps define your individual risk tolerance.

As for the “correct” answer, that is unique to the investor. And the level of investment risk assigned to ABC.

We will consider these examples when we get to the risk-return discussion.

Next up though, the two components of investment risk and factors that influence them.

Pure Risks

by | Feb 8, 2017 | Risk

Although not an investment or speculative related risk, understanding a little about pure risks is worthwhile. If for no other reason than clearly distinguishing from an investment type risk.

Pure risks have only two possible outcomes. Either there is no change in status or there is a loss experienced. You cannot gain from a pure risk. Assuming, of course, you are not trying to defraud your insurer.

So what exactly is a pure risk?

Types of Pure Risks

Pure risks include personal, property, liability, and the failure of others.

Personal risks involve death, disability, and unemployment. An accident that leaves one disabled or dead, or being laid off from one’s job are examples of personal risks. In addition to health and life issues, personal risks may negatively impact current income streams, future earnings potential, and result in an increase of short and long term health care costs.

Property risks involve theft or damage to one’s property. A stolen car or fire to one’s house are examples of property risks. These risks may result in both direct and indirect losses. If your car is involved in an accident, you will need to repair the damage or replace the vehicle. That is the direct cost. But you will also need to pay for alternative transportation until your original vehicle is repaired or replaced. These other outlays are indirect costs (and losses to you).

Liability risks involve the legal system. If it is determined that property damage, personal injuries, or financial loss incurred by another party are the result of carelessness or negligence on your part, you may be liable for monetary damages or other penalties. If you own a business and someone slips on the icy sidewalk outside the front door, you may be liable for medical costs and lost earnings of the injured party. You may also be required to pay any other penalties that a shrewd plaintiff’s lawyer can obtain.

Failure of others risks are those where you suffer a financial loss when others fail to perform a service or meet an obligation to you. For example, you contract to move into new office space effective January 1. However, the provider has not completed renovations by that date. You must then find alternate office space until the renovations are done. Unless this is covered in the rental agreement, you will suffer financial loss by needing to pay for the other space.

Perils

In each case above, there must be both perils and hazards present.

A peril is simply a loss incurred by death, disability, illness, accident, lawsuit, dishonesty, carelessness, or negligence. Pure risks exist because of perils.

Hazards

A hazard is something that increases the probability (i.e. the chance or likelihood) of a peril occurring. It may also affect the severity of the loss.

Hazards may be physical, moral, or morale.

A physical hazard is a physical condition that increases the likelihood of a loss (peril) arising. Smoking in bed (hazard) increases the risk of a house fire (peril).

A moral hazard results from human traits such as dishonesty. Allowing staff access to the cash register (hazard) may increase the probability of employee theft (peril).

A morale, as opposed to moral, hazard is slightly more abstract. It involves inaction or indifference on the part of an individual. Ironically, insurance is a major contributor to morale hazards. For example, you live in an area of the city that experiences a high level of car thefts. Without auto insurance you would likely take several steps to secure your car at night. Tire locks, clubs for the steering wheels, expensive alarms and tracking systems. You would also ensure that nothing of value was left in the vehicle. But once you have auto insurance, the level of concern probably falls. You know that if there is a theft you will be covered by your insurer. That indifference, or lack of action, is the morale hazard.

Obviously, hazards may be interconnected. If you live in parts of Florida, there is a physical hazard of hurricanes during the year. That hazard increases the probability of property damage or personal injury (perils). Without insurance residents would take significant precautions to prevent damage. When I lived in the Cayman Islands, that included knocking coconuts from their trees before a hurricane. Once the wind starts blowing, those tasty treats become deadly cannonballs. Lacking insurance, there would also be a lot fewer people living in traditional hurricane zones.

But with insurance, residents take less precautions to safeguard their property. Beachfront homes are full and many residents remain during the storm. These are morale hazards that combine with the actual physical hazard.

After the hurricane, residents file insurance claims for damage. Maybe the roof that already needed new tile is suddenly damaged by the storm winds. Or the flooding destroyed a (previously broken) “mint condition” television. Filing a dishonest or fraudulent insurance claim is an example of a moral hazard.

Hopefully that gives you a quick, but adequate, overview of pure risks. Next up, a look at investment risks.

Introduction to Risk

by | Feb 3, 2017 | Risk

Let us move on now from discussions of financial advisors and into core investment topics.

The concepts of risk and return are key to understanding the investment process. If you can get your head around the relationship between risk and expected return across the different asset classes, you will become a much better investor.

Investors wish to maximize their returns while minimizing risk. Asset classes are compared on the basis of their risk and their risk-return expectations. Hedging activities are conducted to reduce risk while leveraging helps to increase risk.

Everything investors do relates to risk and return. But what is risk?

Risk

In general, risk is the probability of harm, loss, or injury occurring in the future. The damage may be emotional, physical, or financial. Fairly straightforward.

Where it begins to complicate is when you apply risk to a specific person. For each individual, risk is a different concept. One based on personality, financial situation, where they live, stage of life, and the unique experiences endured in life. Because of this, one’s perception of risk changes over time.

When young and carefree, there is no thought of death. But suddenly you get married, buy a home with a large mortgage, and have a child; your views probably change. What will happen to my family if I am suddenly gone? Life insurance becomes a very interesting topic.

Moving to the Caribbean from Western Canada, I developed a keen interest in hurricanes and tropical storms. And much less concern about icy roads and freezing pipes. Same person, but circumstances had changed in life. And so too my views of risks.

Just look at your own life. To some extent, how you view risk is likely different than friends and family. As well, over time your risk perspective and tolerance will adjust with new situations.

Risk may be categorized in many ways.

As you may hear or read about different terms for risk, let us quickly review the major classifications. That way, if someone mentions risk to you in a different context than the ones we discuss in detail, you will have some idea what they are referring to.

Fundamental Versus Particular Risks

You may see risks compared as fundamental or particular.

Fundamental risks are impersonal in nature and affect a large number of people simultaneously. War, hurricanes, and inflation are examples of fundamental risks.

Particular risks are the result of individual events and the results are much narrower. House fires, car theft, and murder are examples of particular risks.

Dynamic Versus Static Risks

Risks may also be contrasted as dynamic or static.

Dynamic risks arise from changes in the environment or economy that impact specific groups. When a dynamic risk occurs, for the individual directly impacted, there will be a loss incurred. However, for others not directly affected, or those nimble enough to quickly change their current situation, there may be opportunities for gain.

For example, as more people obtain their news electronically there has been a significant reduction in newspaper readership. This has caused many layoffs and bankruptcies. However, some internet news organizations have grown and prospered at the expense of old media.

Or consider that government regulations on fuel and carbon emissions have resulted in a significant restructuring of the auto industry. While this negatively affects those producing Hummers, makers of hybrid vehicles are benefiting.

Static risks, in contrast, are present even if there are no changes in the business environment. The risk is a constant regardless of the situation. Even when everything is going well there will be always be a percentage of people that suffer a loss.

For example, when the stock market is experiencing a lengthy bull market (i.e. broadly rising), some investors will still lose their capital. Or during periods of strong economic growth, there will continue to be individuals laid off from work. There is a risk of loss in good times, not simply the bad.

Pure Versus Speculative Risks

Finally, risk may be classified as either pure or speculative.

A pure risk may be either fundamental or particular. It may also be dynamic or static. However, a pure risk can only have two possible outcomes; a loss or no change in status. The potential loss from an earthquake, house fire, or losing one’s job are pure risks.

Unless you defraud your insurance company, you cannot prosper from a pure risk.

Speculative risks are different from pure risks in one important area. A third possible outcome exists. Like pure risks, speculative risks may have the potential for loss or no change in status. But there is also the possibility of incurring a gain.

Buying a common share of a public company is a speculative risk. When selling, you may lose some or all of your investment. You may also sell for the same price as you paid, thereby experiencing no change in status. Or you may make a profit on the sale.

Some people believe that, at times, dynamic risks can also be considered speculative risks. That is because they see individuals prospering from the impact of a specific dynamic risk. I understand the point but prefer to view them separately.

With a dynamic risk the potential gain is due to subsequent actions. The government introduces minimum fuel standards. Automakers that do not comply suffer a loss. Those that are agile enough to start a new business or adjust their current capabilities may prosper. But it is the subsequent actions that leads them to the opportunity, not the risk itself.

With a speculative risk, it is only the initial decision that results in a gain, loss, or no change. A speculative risk might be the business decision to develop and market an electric vehicle in anticipation of new laws affecting gas consumption. If the business decision is correct and new laws are enacted, the company may do well financially. If there are no laws imposed, consumers might stay with gas powered autos and the business may fail.

That business decision is the speculative risk. Investing is always a speculative risk.

We will focus on speculative risk because of its relationship to personal investing. And, if you do not mind, I will change the label from speculative risk to investment risk. This will save some potential confusion down the road when we look at speculation as a distinct component of the investment process itself.

Before we get into investment risk, we shall consider its counterpart, pure risk.