What do you consider risky? Are stocks risky? Sure, but remember that over any rolling five year period stocks rarely lose money, and almost always outperform bonds. So, it brings up other questions, such as time horizon, tolerance for short term volatility, etc. What about bonds, are they risky? Most would say no. Hold to maturity and you get your principal back. Is real estate risky? Until about a year ago many thought the answer was no. They heard from their realtor that there has never been a year-to-year national decline in housing prices. Oops, until last year. Certainly cash isn't risky, right? I mean, cash is king. Can't lose any of it if it's stashed under the mattress. Except for in a fire or theft.
Well, risk is a funny thing. It comes in all shapes, colors and sizes. Most people think of risk in one way, "what are the chances that I can lose money?" No doubt, that's a real risk. On a short term basis, the most real risk. However, economists and investment people over the years have made a game of seeing who can come up with more types and definitions for risk. They use words like, "idiosyncratic risk," to sound smart.
So, let's break down what we mean by risk. Essentially, there are two major categories of investment risk, and seven major types that fall under those two categories. The first major risk category is what I just referred to, unsystematic risk, also known to us investment nerdy types as the aforementioned idiosyncratic risk.
Unsystematic Risk
Unsystematic Risk is the diversifiable component of total risk. It is risk that is specific to a particular stock, bond, REIT, mutual fund, piece of real estate, gold bar, Ben Franklin or Babe Ruth rookie card. It is considered diversifiable because the ownership of several not highly correlated assets will reduce the total risk. For example, if you own only one stock, um, let's call it Enron. Let's say it goes down a lot, like say to zero. Your loss is total. By owning one more stock in equal amount, which doubles in that same time frame, your loss is... nothing. You break even. The major types of unsystematic risk are business risk and financial risk. Or in the case of your Babe Ruth rookie card, misplacement risk or spilling coffee risk.
Business Risk. Business risk is the risk associated with the nature of the business. Frequently, companies in the same industry carry similar risks. This is why owning thirty different dot-com stocks in 1999 was not proper diversification.
Financial risk. This is the risk attributed to the use of debt by a company. Greater debt equals greater financial risk. For example, if homeowners were companies, most new homeowners would involve significant financial risk.
Systematic Risk
Systematic risk is the nondiversifiable component of total risk. This is the risk that is generally associated with an entire class of assets. There may be a decline in price levels to the entire market due to economic conditions, changes in Fed policy, the declining popularity of baseball, who knows? This is nondiversifiable because it assumes that the ownership of a larger number of stocks will not reduce this type of risk. The major types of systematic risk are interest rate risk, reinvestment rate risk, purchasing power risk, exchange rate risk, and market risk.
Interest Rate Risk. This applies more to fixed income assets, such as bonds. It is the risk that rising rates will cause the price of bonds to decline. Owning a large number of bonds will not reduce your risk if prevailing rates rise. Some stocks with historically high dividends, such as utility stocks, are also subject to interest rate risk.
Reinvestment Rate Risk. This is the risk that cash flows from an investment, such as interest or dividends, will not be able to be invested as favorably, perhaps due to declining rates. This does not apply to assets that do not generate any income, such as Ben Franklins, non-dividend paying stocks, or the Babe Ruth rookie card.
Purchasing Power Risk. Also known as inflation risk. Simply, it is the risk that a dollar tomorrow will not be able to buy as much as a dollar today. You know, like gasoline, postage stamps, Laker tickets. Specifically, it is the risk that your investment will not grow as much as inflation.
Exchange Rate Risk. When investing in foreign markets, your purchasing power domestically may decline if the dollar is rising in value versus the currency in which you are invested. There seems to be little risk of this recently.
Market Risk. This is the overall risk that most people think of when they remember the crash of the NASDAQ. It is the risk that we have a bear market and the clear majority of stocks decline. Of course, it begs the question, which market? In 2000 and 2001, domestic small caps were doing fine, as were many foreign markets. In fact, stocks in the U.S. that would be considered "value" stocks fared rather well. Unfortunately, the nightly news is dominated by large U.S. growth stocks, which many people refer to when they say, "the market."
Okay, so that's all the dry economic/investor definitions. But there are two other types of risk that we see all the time that, frankly, are more real types of risk. I'm thinking that they are very important and I don't want to bury them at the bottom of an otherwise snoozer of a post. So, they'll appear in another post shortly.
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