Part 1 – Introduction to Risk
In personal finance, everyone hopes that their investments shoot straight up forever without any issues…However, reality is not nearly so predictable / linear and sometimes things just happen because they do.
Over the past year, the global and specifically the US stock markets have experienced an almost relentless path upward in value – See the S&P 500 chart below.
However, this may not be the same market result in 2020! It is quite possible that 2020 may be a down year overall or at least one with increased volatility.
This then naturally brings us to the topic of market risk.
Market Risk – What is it?
According to the financial dictionary, market risk is also known as systemic risk by the following definition:
A risk that is carried by an entire class of assets and/or liabilities. Systemic risk may apply to a certain country or industry, or to the entire global economy. It is impossible to reduce systemic risk for the global economy, but one may mitigate other forms of systemic risk by buying different kinds of securities and/or by buying in different industries.
So based on this definition, you may be more confused then ever. However, if we break it down there are a couple of points to pay attention to – Assets have risk, specific industries have risk and the overall global economy has risk. So let’s break down these terms now.
Asset risk is a type of risk that is implied by owning a certain type of investment (or asset type). The most common types of assets are Stocks, Funds, Bonds and Real Estate. Each of these items has it’s own inherent risk profile (how risky they are; how prone to drop in value) associated with them. There are huge fields of research into the risk profiles of each of these assets that is beyond the scope of this article. However, if we compare each of these assets to each-other, we can see the relative risk profile of each.
Stocks – Tiny ownership fractions of a company available for sale on markets (Stock Markets) that can be bought and sold by private individuals, groups, public entities, large institutions and others. Stocks are sold on the open market and represent ownership in a company. The value of these stocks fluctuates everyday based on market conditions; risk is highest.
Funds – A group of stocks, bonds, real estate – acts as a collection of the underlying asset and has a risk profile associated with the asset type (see stocks, bonds, real estate). These are typically sold as mutual funds (group of funds) or exchange traded funds (group of funds); risk of funds is the same as the underlying asset class or what they are invested in.
Bonds – The issuance of debt as a loan, with interest payment, by either a private company, government or another body. This asset class pays an interest payment and the face value (original value) of the bond; risk of bonds is lower then stocks but still risky based on the government or company that issued the bond.
Real Estate – The ownership of a physical property either by individual, government or company for use or investment. This asset class can pay “interest” in form or rental income and the value of real estate can fluctuate up or down depending on market conditions; risk of real estate is average due to economic conditions, location and type or value of property.
Measuring Asset Risk
Investment risk is determined by a financial term called Beta – this measures the intrinsic risk of that asset based on the relationship to the overall market.
The beta calculation is used to help investors understand whether a stock moves in the same direction as the rest of the market, and how volatile or risky it is compared to the market.Investopedia
Therefore, if we see an asset class with a Beta score of 1.0 it mirrors the risk level of the overall market, higher than 1.0 means it is more volatile than the overall market and less than 1.0 means it moves more slowly than the market. A beta of -1.0 or more means it moves opposite to the movement of the market.
Global Economic Risk
Another type of risk is the overall global economic environment; no country or industry is “an island” or unaffected by what is happening in the world. If there are environmental issues happening, war, natural disasters, political issues or a host of other conditions happening, it will affect the global stock markets – As the saying goes “Be ready, it’s going to rain”, things will either turn better or worse at anytime; be ready for either case.
Conclusion (Part 1)
Therefore, now that we know about the different types of risk when investing, in future posts, let’s review how we can balance the asset class risk and see if we can improve our chances of maintaining portfolio growth and minimizing the downward risk of loss.
The next step in this process of minimizing asset class risk is to define the portfolio assets and the percentage of each; called asset allocation in the financial world.
Note: For now in Part 1, we have introduced the concepts of Market Risk and Asset Risk. In Parts 2 and following we will further breakdown asset allocation patterns and determine how to best structure a portfolio to protect your investments in the case of a downturn and be ready for additional upward momentum.
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