We hear about risk in almost every facet of our lives, and investing is no different. You hear people telling you to acknowledge risk, to identify risk, to avoid risk, but what does it all mean?
Risk as Beta
Unfortunately, the most common statistic which is associated with the risk of an equity is its “Beta”. Beta represents the volatility of a security relative the market as a whole. A Beta of less than one means that on average for a one percent increase in the value of the stock market, the individual security increases by less than one. Whereas a Beta greater than one means that on average when the market moves up by 1 percent, the security increases by more than 1 percent.
Why is this used?
Beta is used as a measure of risk not because it is the most accurate measure, but because it is the easiest to quantify. In truth, Beta measures volatility, not the risk.
When is it appropriate?
Beta can be useful for short term trading when the volatility of a stock is a more accurate measure of risk. Another helpful use of Beta is when trying to diversify a portfolio. Although it is more effective to examine the actual correlation between two stocks, Beta can be used as well, particularly if you are looking to add to a portfolio comprised mainly of index funds.
Shortcomings of using Beta to measure risk
Investment should be undertaken with a long term time horizon, given this perspective, volatility is of limited importance. In addition to this, the beta only measures past importance, it is completely unaffected by the potential developments for the individual company, industry, and market as a whole.
How you should define risk
So if Beta is not an appropriate measure of risk for the long term investor (hint: if you are investing in equities, this should be you) then what is? Below I have listed a number of types of risk that you should consider before investing.
What are the chances that a stock trades permanently lower or goes bankrupt (Specific risk)
These are risks that pertain only to the individual company you are considering investing in. Perhaps customer dissatisfaction with their product is growing, a new competitor is eating away at their market share, or they are unable to innovate and stay relevant. These are just a few examples of the plethora of possible ways that companies intrinsic value can decrease over time. The likelihood of any one of these potential developments coming to fruition is not reflected by the Beta value of a company but must be considered by the investor.
What are the chances a bond is defaulted on (Default risk)
Default risk is the possibility that a company will be unable to meet one of its future interest payment obligations, and is thus forced to default on its debt (Declaring bankruptcy). Factors that lead to the defaulting of debt are typically the same as those listed above as specific risk, but economic risk and industry risk can also force less established companies into bankruptcy.
This type of risk is most aptly defined as the potential for a change in investors sentiment. The best example of this is the tech crash of the early 2000’s. In what felt like the blink of an eye tech companies collapsed to tiny fractions of their previous values, not because the fundamentals of the company, industry, or even the overall economy had changed, but because investors realized that the valuations they had previously put on these companies defied all logic.
This represents the risk the economy of the country in which the company you are looking to invest in operates undergoes a recession. When people are laid off, hours are reduced, and bonuses are cut, people have less money to spend and save. This means corporate profits are reduced, making investing in companies less attractive. It also means that individuals have less money to pour into mutual funds and invest. Both of which tend to result in falling stock prices all across the board. The more recent example of this was the financial crises in 2008. If you look at the stock chart of almost any company, you will see a sharp drop somewhere between 2007 – 2009. While there is not much that can be done to protect against this sort of risk (aside from hoarding gold and/or cash), it is important to be aware of it.
There is also risk associated with each individual industry. While some industries are more volatile than others, industries as a whole tend to undergo extended periods of advance and decline, and on rare occasion, industries are wiped out altogether. Take the horse and buggy industry for example. At one time the only way to get from point A to point B quickly was by traveling via horse and buggy. They were everywhere, and the industry was thriving. Then suddenly the automobile was invented, and within a matter of years, the horse and buggy industry was non-existent. While this is not a common occurrence, a declining industry is. Will the oil and gas industry go the way of the horse and buggy over the next 500 years? Tough to say for sure, but it is something worth considering.
Blacks Swan Event
What is it?
The term black swan was made famous in investing circles by Nassim Nicholas Taleb, thought by many to be the top authority on investment risk. The basic idea behind it is that there are known risks (many of which were described above) and then there are unknown risks. Sometimes referred to as the unknown unknown, things that we don’t know we don’t know. This type of occurrence is called a black swan event. A common example of a black swan event was the attack on the world trade centers on September 1st, 2001. Up until that time, no one would have even considered this type of attack as a possibility. The US treasury bill is generally considered the “risk-free” rate of investment, but is it really? The United States suddenly being forced to default on its treasury bills would be a black swan event.
Can you protect against it?
It is difficult, and sometimes may be impractical. The idea here is that even when you think you are avoiding all risk, and accepting a much lower return because of it, you are likely still exposing yourself to disaster via a potential black swan event.
How can you profit from it?
You can. In fact, Taleb has made a small fortune doing just that. He makes a series a very small “bets” on a black swan event occurring. Since very few people even consider these events as possible, the relationship between the payout and the odds is heavily skewed in his favor. When he loses, he loses a small amount, but when he wins, he wins big.
If you want to learn more about black swan events, check out the two books written by Nassim Nicholas Taleb on the subject; “Black Swan” and “fooled by randomness”.