Delve Deeper into Risk - dummies

By David Stevenson

Intuitively everyone understands the simple concept of the risk/return trade-off. As your appetite for greater potential returns grows, so must your willingness to take on more risk. You don’t get something for nothing in the world of finance, in the UK or anywhere else, and if you want ‘sooper-dooper’ returns, be prepared to take larger risks.

Risk is a fairly slippery customer and comes in lots of different types. Unfortunately many private investors look at risk in a very simplistic way — a typical query about risk may start with an investor asking, ‘How much of my initial capital may I lose if I invest in an asset?’ But risk involves much more than this narrow sense reveals.

As an investor, you need to think about risk in a much wider, more holistic sense. Risk can mean any or all of the following:

  • Credit risk: If you buy a bond, what’s the chance of the issuer defaulting on the final payment (or the regular interest payments)?

  • Currency risk: Your investment in a foreign asset may increase in value but the currency in which it’s denominated may move in the opposite direction.

  • Idiosyncratic risk: If you employ a manager to manage your money, what risk are you taking if he makes a bad decision?

  • Legal risk: Will regulators decide to change the rules governing your investment?

  • Leverage risk: What happens if you borrow too much money and the cost of leverage starts to work against your investment?

  • Liquidity risk: Your asset may increase in value but become increasingly difficult to sell; that is, it may become more illiquid, which is a risk if you need to access that investment immediately to raise some much-needed cash!

  • Maximum drawdown: The potential maximum loss over a period of time that may hit your financial asset. Many stock markets can easily lose 20 or even 30 per cent in a year; whereas most bonds rarely lose more than 10 per cent in any one year.

  • Systematic risk: How an asset may respond to risks within the system; that is, how closely correlated the asset is with wider financial assets. If the US economy nosedives, is your asset going to crash in value as well?

  • Volatility: How much the value of a share, bond or commodity varies on a daily basis. For many people, high volatility implies higher potential risk.