Updated: May 2
This month’s ‘for your consideration’ will be a quick lesson about the ‘whys’ of asset volatility. What makes the value of an asset go up and down and how can we manage through the bounces. How well an investment performs is based on more than just its inherent value or public demand. Sometimes performance can be influenced by which way the wind is blowing……literally. Sharpen your pencils class, today we will learn about risk.
There are two fundamental types of risk, systematic risk and unsystematic risk. Systematic risk is a risk that affects a large number of assets at one time. The condition of a government’s economy or a country being at war are examples of systematic risk. Unsystematic risk effects a small number of assets. Earnings reports or a company strike are examples of unsystematic risk.
Within these two broad categories there are several specific types of risks:
Credit or Default risk – The risk that a company, group or individual will not be able to pay their contractual interest or principal on debt obligations.
Country Risk – The risk that a country will not be able to honor its financial obligations.
Foreign Exchange Risk – The risk tied to monetary exchange rates.
Interest Rate Risk – A topical category, this is the risk that an investments value will go up or down depending on a change in interest rates.
Political Risk – Risk tied to changes in government policies. Hillary’s recent take to twitter about pharmaceutical price gauging is a great example of this risk class.
Market Risk – aka, volatility or fluctuations in market prices.
Acts of God – this relates to natural disasters and their effects on economies and ties into political risk to a degree. The Japanese tsunami in 2011, when the Asian markets fluctuate wildly is a good example of this type of risk.
So, what is our take away? Well, first and foremost, the above list shows that prognosticating the short term potential of investments is only valuable, as Warren Buffet puts it, to make fortune tellers look good. After all, what investment forecaster could have predicted an earthquake and resulting tsunami?
While controlling risk might be near impossible, being aware of risk and acting accordingly can decrease the effects on your portfolio. Diversification is the primary defense against risk, especially unsystematic risk. Never invest in one stock, one field, one asset type, one country’s stocks, etc.
Understanding the existence of risk also makes investors smarter. There is no sure thing, and the smart investor will accept that all invested money is assets at risk. Money that cannot be at risk should not be invested.
So know yourself…..what is your tie horizon? What level of volatility can you afford and still meet your financial goals? And of course, what are the risks involved? Learning what you are up against when you put your money into different types of assets gives you the power to make the right decisions. Once you have an understanding of what you are getting into, let it ride!