What is risk?
At its most basic level, risk can be defined as the extent to which actual investment performance may deviate from expectations. Defining and establishing appropriate expectations is a critical aspect of a financial advisor’s business.
Prior to joining CMG Capital Management Group, while working as a consulting Actuary; I made a living by putting a price tag on risk. Insurance companies need to be reasonably convinced that the premiums they charge their clients will be sufficient to cover future claims, administrative and operating expenses, and provide profit while constantly maintaining a competitive premium level in order to attract and retain clients. This is a complicated endeavor which involves more than a bit of science as well as art. Having a sound understanding of risk is critical to being able to quantify it.
Here at CMG, we often spend time discussing risk with financial advisors to help them appropriately allocate their clients’ portfolios. Often what appears to be a well diversified portfolio from an asset allocation perspective turns out not to be well diversified from a risk perspective.
Advisors need to consider risk when discussing investment options with clients. Understanding and communicating potential risk exposure within an investment portfolio is critical to attracting and retaining clients. As we mentioned earlier, risk is deviation from expectations. It is well documented in Behavioral Economics, as noted in the seminal paper on Prospect Theory by Kahneman and Tversky, that investors attach more emotional significance to investment losses rather than gains. By managing risk exposures rather than asset allocations, advisors and clients are more likely to stick to the financial plan.
Broadly, investment risk can be categorized as either Systematic or Unsystematic. Systematic risks, such as the Great Recession of 2008, affect a broad number of asset classes. Unsystematic (or specific) risk affects a specific company or industry such as a management change or regulatory change. Going a bit deeper, the following is a general list of risks investors could be exposed to:
- Credit (or Default) Risk measures the ability of a company to meet its debt obligations. Credit risk is a critical component of fixed income investing.
- Country Risk is the exposure to changes in the business environment of a particular country having adverse affects on assets in a specific country.
- Foreign-Exchange Risk is that of an investment’s value changing due to exchange rate fluctuations between two countries.
- Interest Rate Risk measures an investment’s value changing due to changes in the absolute level of interest rates, the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship. Virtually all investors are exposed to some level of interest rate risk. Given recent comments from Janet Yellen indicating the central bank could begin raising interest rates early in 2015, investors are increasingly concerned with interest rate risk.
- Market Risk is that of an investment’s value changing due to movements in market prices.
All of these can be inter-related. For example, Country Risk can be considered a specific type of Credit Risk. Having a deep understanding of risk is the first step in being able to communicate the impact of it, set appropriate expectations and allocate client portfolios accordingly. In subsequent posts we will discuss how to measure risk as well as the concepts of diversification, asset allocation and correlation in more detail. – Michael Hee