Investment companies and the financial media generally spend most of their time focused on returns and other benefits of the various investment opportunities they recommend.
Yet when it comes to communicating the risks associated with those investments, the industry is a lot less forthcoming, according to Larry Doyle, author of “In Bed with Wall Street: The Conspiracy Crippling Our Global Economy” (Palgrave Macmillan, 2014).
Doyle argues that most investment offerings and financial products are intentionally vague in terms of detailing the true embedded risks, leaving retail investors and even some institutional advisers in the dark about the real trade off between risk and return.
It’s a maxim that risk and return go hand in hand. Suppose that there were two investments in the market from which you could choose. Both have equal risk, but investment A offers a 5 percent return while investment B offers 10 percent. No one would choose investment A, forcing the investment company either to increase its return or to go out of business. The only way people would be willing to invest in a lower-returning investment such as A would be if A could demonstrate that the risk associated with its investment was lower than that of B. Looking at this another way, investors always demand a premium in the form of a higher return in order to invest in something with higher risk.
If companies selling financial products obscure the risks associated with them – according to Doyle, “Disguising risk is an art form on Wall Street” – how can you adequately determine the risks in any investment you would consider? The first step is to understand the possibilities. Following is a list of some common risks associated with most investment opportunities that you might consider.
• Volatility risk. How volatile is the investment? Volatility is typically measured as the standard deviation of returns over time. If you’re the type to lose sleep when the stock market dives, or expect to need the money for something in a relatively short time frame, you should probably try to avoid high-volatility investments.
• Market risk. How does the value of the investment fluctuate relative to that of the market in which it operates? In the stock market, this is known as a stock’s beta. Higher-beta stocks have higher returns when markets rise but lose more when they drop, and vice versa.
• Liquidity risk. How quickly and easily can you sell the investment if you need to? If you invest in commercial property, for example, you may require a higher return to compensate for all the costs and hassles that can occur from an unexpected need to sell prematurely.
• Interest-rate risk. How do interest rates affect the value of the investment? While this is especially important for bonds, it affects preferred stocks and numerous other types of investments as well.
• Credit risk. Applied to various types of loans such as bonds or mortgages, it’s the likelihood that a borrower will fail to make the required payments. As the lender, how much can you expect to collect if such an event occurs?
• Counterparty risk. Similar to credit risk, but applicable to investments such as derivatives, insurance or other transactions.
• Prepayment risk. The likelihood that a borrower would pay back a loan prematurely, impacting the valuation of the investment. This risk is highest for bonds with call features and with mortgages.
• Currency risk. How dependent is the return on a specific currency or basket of currencies, and how does it change as those currencies shift in valuation?
While it may be difficult to assess all the risks in any investment, the more you can identify and quantify, the better positioned you’ll be to decide whether or not the investment is right for you.