Of all possible questions which the investor may ask, the most important one is concerned with the probability of actual yield being less than zero, that is, with the probability of loss. This is the essence of risk. A useful measure of risk should somehow take into account both the probability of various possible “bad” outcomes and their associated magnitudes.
Instead of measuring the probability of a number of different possible outcomes, the measure of risk should somehow estimate the extent to which the actual outcome is likely to diverge from the expected.
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4 Ways to Manage Investment Risk
Investment planning is almost impossible without a thorough understanding of risk. There is a risk/return trade-off. That is, the greater risk accepted, the greater must be the potential return as a reward for committing one’s funds to an uncertain outcome. Generally, as the level of risk rises, the rate of return should also rise, and vice versa. Before we discuss risk in detail, we should first explain that risk can be perceived, defined and handled in a multitude of ways. One way to handle risk is to avoid it. Risk avoidance occurs when one chooses to completely avoid the activity the risk is associated with.
An example would be the risk of being injured while driving an automobile. By choosing not to drive a person could avoid that risk altogether. Obviously, life presents some risks that cannot be avoided. One may view risk in eating food that might be toxic. Complete avoidance, by refusing to eat at all, would create the inevitable outcome of death, so in this case, avoidance is not a viable choice. In the investment world, avoidance of some risk is deemed to be possible through the act of investing in “risk-free” investments.
Short-term maturity United States government bonds are usually equated with a “risk-free” rate of return. Stock market risk can be completely avoided by one choosing to have no exposure to it by not investing in equity securities.
Another way to handle risk is to transfer the risk. An easy-to-understand example of risk transfer is the concept of insurance. If one has the risk of becoming severely ill (and unfortunately we all do), then health insurance is advisable. An insurance company will allow you to transfer the risk of large medical bills to them in exchange for a fee called an insurance premium.
The company knows that statistically, if they collect enough premiums and have a large enough pool of insureds, they can pay the costs of the minority who will require extensive medical treatment and have enough left over to record a profit. Risk transfer can also occur in investing.
One may choose to purchase a municipal bond that is insured. One may purchase a put option on a stock which allows that person to “put to” or sell to someone their stock at a set price, regardless of how much lower the stock may drop. There are many examples of risk transfer in the area of investing.
Risk Averse Investor
Do investors dislike risk? In economics in general, and investments in particular, the standard assumption is that investors are rational. Rational investors prefer certainty to uncertainty. It is easy to say that investors dislike risk, but more precisely, we should say that investors are risk-averse.
A risk-averse investor is one who will not assume risk simply for its own sake and will not incur any given level of risk unless there is an expectation of adequate compensation for having done so. Note carefully that it is not irrational to assume risk, even very large risk, as long as we expect to be compensated for it. In fact, investors cannot reasonably expect to earn larger returns without assuming larger risks.
Investors deal with risk by choosing (implicitly or explicitly) the amount of risk they are willing to incur. Some investors choose to incur high levels of risk with the expectation of high levels of return. Other investors are unwilling to assume much risk, and they should not expect to earn large returns.
We have said that investors would like to maximize their returns. Can we also say that investors, in general, will choose to minimize their risks? No! The reason is that there are costs to minimizing the risk, specifically a lower expected return.
Taken to its logical conclusion, the minimization of risk would result in everyone holding risk-free assets such as savings accounts and Treasury bills. Thus, we need to think in terms of the expected return/risk trade-off that results from the direct relationship between the risk and the expected return of an investment.
Influence of Time on Risk
Investors need to think about the time period involved in their investment plans. The objectives being pursued may require a policy statement that speaks to specific planning horizons. In the case of an individual investor, this could be a year or two in anticipation of a down payment on a home purchase or a lifetime if planning for retirement.
Generally speaking, the longer the time horizon the more risk can be incorporated into the financial planning. Time has a different effect when analyzing the risk of owning fixed income securities, such as bonds. There is more risk associated with holding a bond long-term than short-term because of the uncertainty of future inflation and interest rate levels.
If one were to “lock-in” a rate of 6 percent for a bond that matured in one year, an upward move in inflation or interest rates would have a less adverse effect on the price of that bond than a 6 percent bond that matured in thirty years. That is because the bond could be redeemed in one year and reinvested in a bond with a presumably higher interest rate. The thirty years bond, however, will continue to pay only 6 percent for the rest of its thirty years life.