The purpose of the Risk Center is to answer common questions regarding investment
risk and clarify misconceptions associated with risk in general.
By its nature, risk only exists in the future, but can only be measured in
the past. In the most fundamental sense, risk equals uncertainty. Risk is not
defined as a negative future event, but rather as an uncertain future event, regardless
of its nature.
Risk is not a bad thing nor should it carry negative connotations; however,
the common concern associated with risk is that the outcome of an uncertain future
event can produce negative results. Risk Center is focused on answering the questions
that concern portfolio risk and the measures that can be taken to deal with it
more effectively.
Is it possible to eliminate investment risk?
Yes, it is possible to eliminate investment risk. The way to do this is to simply
invest your money in one-month United States Treasury Bills. The U.S. government
is considered to be the highest quality creditor in the world, and therefore,
an investment in short-term T-bills is essentially a guarantee against any loss
of investment principal or interest.
If risk can be eliminated, why should anyone be willing to accept
risk in a portfolio?
The simple answer is, “No risk = no reward.” While it is true that
U.S. T-bills constitute a risk-free investment, it is also true that U.S. T-bills
provide very little in the way of investment returns compared with other investments
such as corporate bonds and stocks. If we think about this logically, we can see
that the market demands that this be true. If the expected return on corporate
stocks, for example, were equal to or lower than the return on U.S. T-bills, no
one would ever invest in corporate stocks. There would be no reason to invest
in the riskier corporate stocks if you could achieve the same expected return
with a risk-free T-bill. Therefore, corporate stocks must offer a higher expected
return than T-bills in order to entice investors to buy them. This higher return
is, in effect, an investor’s reward for taking on more risk. In a well managed
portfolio, more risk = more reward.
Is there a difference between short term and long-term risk?
Yes. Short-term portfolio risk is driven by market volatility. As risky investments
rise and fall over time, the holders of these investments are exposing themselves
to the risk that they will need to “cash-out” during a downward trend
in the market. Thus, dealing with short-term risk involves coping with uncertainty
and the ability to “stay the course” through difficult periods in
the capital markets. Long-term risk, on the other hand, is associated with the
deterioration of capital due to the effects of inflation. Any investor who does
not utilize some of the higher expected return investment vehicles (such as corporate
stocks) runs the risk that inflation will destroy the purchasing power of his
initial investment. Historically, the long-term risk driven by the effects of
inflation has been much more dangerous to an investor than short-term risk driven
by volatility.
Are certain types of risk avoidable?
Yes. There are two types of risk: unavoidable and avoidable risk, or non-diversifiable
and diversifiable risk. Academics refer to these as systematic and non-systematic
risk. Certain risks are implicit in the capital markets because of the volatility
associated with macro factors such as the global economy or the demand for equities
and bonds. These risks must be borne by all investors and cannot be diversified
away. However, many investors also bear a large amount of avoidable risk by betting
on one country, one class of stock, or even a single stock. Comprehensive Diversification
eliminates this diversifiable risk and reduces future uncertainty by spreading
investments among many different and relatively uncorrelated asset classes. By
diversifying among multiple asset classes as well as within each asset class,
an investor will be exposed only to those particular risk factors that are absolutely
necessary.
If I already own fifty stocks, why do I need more diversification?
Diversification is not defined by how many securities you own, but how the
securities you own interact with one another. Owning fifty large cap U.S. stocks
will not provide a great deal of diversification because they may all move lower
at the same time in the case of a general slump in the U.S. economy. However,
owning real estate investment trusts, small capitalization stocks, foreign securities
and bonds in conjunction with U.S. large cap securities protects against a general
decline in large cap U.S. stocks, or in any single asset class.
Is a well-run company always a great investment?
Not necessarily. There is a common misconception among investors that if a
company is a well-run “household” name, it must be a good investment.
Investors must be aware that a good company does not always equate to a good investment
because the price of the position (stock or bond) in the company could be significantly
above the underlying intrinsic value of the company itself. If everyone knows
that a company is well run, everyone will want to buy it. This buying pressure
may increase the price to an unsustainable level, and although the company is
still well-run, its stock or bond price could drop dramatically in response to
adverse events beyond the company’s control.
Should I base my investment decisions on what has happened in
the past?
No. As investors are always told, “Past performance is not indicative
of future results.” This statement is true in every sense. You should never
invest based upon past performance because the past is simply not an effective
predictor of the future. The fact that technology stocks showed outstanding performance
from 1994-1999, did not prevent them from delivering disastrous results in 2000-2002.
Investment decisions should be based on investment fundamentals, and viewed as
if every day were the first day of the investment life cycle.
I am concerned about terrorism. Should I be investing now?
There is no accurate method of predicting the timing or frequency of major
geopolitical events. This question, however, illustrates the difference between
short term and long-term risk. The impact of a terrorist event will likely be
short-term in nature. As long as a portfolio is properly diversified and the investor
is able to recognize the terrorist event as a short-term event, the resultant
short-term volatility should not cause the investor to alter his or her long-term
investment plan. However, failure to invest in the market due to fears of terrorism,
energy prices, or other short-term factors exposes an investor to the long-term
risk that the effects of inflation will erode his or her wealth. In other words,
over the long-term, the risk of being out of the market will most likely exceed
the risk of being in the market.
The most important controllable risk in the field of portfolio management is the
risk of not having a well-conceived investment plan or the ability to implement
that plan, especially in times of uncertainty. Investing is an emotional process
that takes acumen, patience and discipline. It is difficult not to panic when
it feels like the world is falling in around you, as it felt like on September
11, 2001. It is just as difficult not to chase hot areas of the market when it
feels like everyone around you is “getting rich”. Because the assumption
of risk goes hand-in-hand with higher expected returns, risk can work to the investor’s
advantage if it is approached properly. Risk is the vehicle that allows a good
investment advisor to establish the right asset mix in each client portfolio.
Risk should not be feared. It should be embraced, and it can be controlled if
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