Becoming an effective investor requires you to properly manage investment risk.
Today we shall look at how this is typically done.
Previously, we reviewed ways to manage pure risks in daily life. These included: risk retention, risk avoidance, risk transfers (including insurance), and loss control.
Some of these tools may also be used to address investment risks. While risk retention may be used, it makes little sense to review in an investment context, so we shall skip any discussion of it.
Risk Avoidance
In some circumstances, you can use risk avoidance to eliminate or minimize the potential impact of certain systematic and nonsystematic risks.
A hurricane is a systematic risk. While you cannot avoid the impact on companies affected by the hurricane, you could avoid investing in companies that operate in hurricane belts, such as the Caribbean or Gulf Coast.
The same applies for political risk. If you have concerns a country may nationalize assets of foreign companies, excluding investments in companies that operate in that country would eliminate this risk. General Motors is a good example.
Management risk is a nonsystematic risk. If you worry about the next Kenneth Lay managing one of your investments, you can avoid buying shares in public companies. Instead, you could invest in money market funds or term deposits to eliminate management risk. Of course, you still need to worry about the fund company and bank.
Investors with extremely low risk tolerance may use this technique to avoid many risks. Unfortunately their investment options are limited and their returns will be low.
Additionally, there are certain risks that cannot be avoided.
If you invest in US government Treasury Bills, you do not (as of this date) have to worry about management or credit risk. However, the risk of inflation can impair or even destroy your invested capital. A decrease in interest rates may create reinvestment risk. Or, a weakness in the US dollar may result in currency risk. And so on.
With each potential investment there are specific risks you can avoid. But also other risks that cannot be avoided.
And each investment will have a different combination of avoidable and unavoidable risks.
Not good, is it?
Well, as we shall see later, this actually has its advantages for investors.
Risk Transfers
Financial markets do a good job of allowing investors to effectively transfer risk to others.
Hedging can reduce risk by transferring risk to other investors or speculators. In fact, that is a key function of speculators. They accept risk from those who wish to hedge their activities.
There are different methods to hedge ones risk exposure in investing.
In addition to pure hedging actions, the use of swaps, derivatives, and other more complex financial transactions can be used to alter the risk-return profile of investments.
An example of a risk transfer is a capital protected mutual fund. This type of fund invests in different investments (e.g. S&P 500 fund, bond fund), yet the fund guarantees your invested capital from loss. Some funds guarantee 100% of your capital, others 90% or less.
The attraction is that you are able to participate in the upside return potential of the underlying investment. Yet you are protected from any downside risk of monetary loss. Note that this would be an example of an asymmetric return profile that we looked at in our limitations of standard deviation discussion.
Pretty good. Risk of outperformance, but no risk of loss.
Of course, there is a cost associated with transferring the downside risk elsewhere. The greater the percentage of capital that is guaranteed, the greater the cost. Depending on the investor, that cost may make these investments unattractive.
There are a variety of ways to create a fund such as this one. Combining a Treasury Bill and a call option is one simple method. However, these are advanced techniques that are outside the scope of our discussion.
We will look at risk transfers, in brief, at a later date.
Loss Control
Loss control involves identifying all risk factors present and attempting to minimize or eliminate the key risks. For key risks that cannot be minimized, one tries to reduce the potential loss should it arise.
The first step is, in part, dealt with above in risk avoidance.
The second step involves prudent investment practices.
Prudent Investment Practices
One important measure is in understanding how to invest.
Hopefully this investment series and ongoing commentary will provide some pointers.
One can also take courses that provide the basics for investing. Many on-line brokerage firms and banks provide internet tutorials and webinars as well. There are many options for improving one’s knowledge on how to invest.
A second measure is to undertake proper research before investing one’s capital.
We will look at investment analysis in detail later this summer. It is not that easy a task. I think it requires some expertise in finance and accounting to properly analyze traditional investments.
For non-traditional investments such as art, collectibles, and even real estate, you also require strong knowledge about the asset itself.
Since I was young, I collected coins. I have some knowledge of them as an asset class and investment. But I know nothing about stamps, so I would never invest directly in stamps.
In fact, I would be leery of seriously investing in coins as well. While I have some knowledge, I could not successfully compete against experts in the field.
I would never play golf against Rory McIlroy for money. Similarly, I would never compete against experts in any other area unless I was equally proficient. If you do, you are playing a fool’s game.
That said, if you learn how to research investments, you can glean valuable information concerning potential risks.
Perhaps you worry about legal or credit risk. You can get clues about the likelihood of these risks arising through analysis. Financial statements, corporate releases, and news items will provide information concerning past, ongoing, or potential litigation. I always find that the best information is buried deep within the notes to the financial statements.
A review of the business can also provide hints for potential problems.
For example, mining and offshore oil companies run a risk of accidents and environmental damage that may result in litigation. Look at Massey Energy or British Petroleum in 2010. Contrast them with Apple. Yes, there may be other legal issues for Apple, but Apple investors need not worry about mine collapses or oil spills causing losses on their shares.
Financial analysts’ reviews and recommendations can also help you find investments that may perform better than average. Not necessarily so, but a good place to begin your own analysis.
A third measure in controlling risk is through your portfolio construction.
The keys here are diversification and asset allocation.
I think that asset allocation is diversification, but most people separate the two, so I shall follow suit.
Diversification and asset allocation are extremely important for investment success.
We will save asset allocation for when we discuss portfolio construction.
But next up, we shall take a detailed look at diversification.
