Risk can be elicited in many ways, shapes, and forms. Unfortunately, the typical retail investor is incognisant of how risk affects them financially. It is not surprising why this is the case. In an industry where there are buyers and sellers of financial products, it is more advantageous for the seller to focus on the rewards, rather than the risks of a product. To find evidence of this, you don’t have to look farther than the terms and conditions of your credit card, line-of-credit, or mortgage –where the contractual details and risks associated with your loan are provided in a conveniently-sized pamphlet with size 6-8 font. Even if you have the prowess to read the artfully-articulated content your loan provider has compiled for you, deciphering and understanding the risks may be difficult, as it is likely littered with jargon unfamiliar to the common consumer. While the disclosure of risk is essential, it is not always conveyed in an honest and simple manner. This is further perpetuated by the financial services industry. We’ve all heard the adage “low risk, high reward” used to describe some investment product. However, in many cases a more suitable phrase might be “too good to be true”. In an industry that is fuelled by confidence, risk can act as an opposing force. In many areas of finance, the disclosure of risk is becoming habitually ignored. It is common to see brokers active to discuss the potential returns on a hot new stock, but passive when it comes to disclosing the risks involved. As a diligent purchaser of financial products, you should be enticed to know about the risks associated with what you’re purchasing. Failure to do so can be detrimental to your financial wellbeing.
Defining your Risk Appetite
Prudent identification, assessment, and management of risk have the potential to increase your net worth and decrease your exposure, leaving you better off financially. At every stage in your financial pursuits, you should have a clear understanding of your risk appetite. Essentially, your risk appetite is precisely the amount of risk you are comfortable being exposed to. First of all, your appetite will (and should) change throughout your lifetime. When you are young, have stable sources of income, and many years of wealth creation ahead you, you may be encouraged to take on more risk. Time is a crucial element in this stage of your life. With a higher risk appetite, you may be attracted to riskier stocks, and with that, the potential for higher reward. Keep in mind that the earlier and more you invest, the greater the effect of compounding. On the contrary, when you are young there is more time to recover your wealth if you realize investment losses. So if you there were ever a time in your life to take on more risk, it should be when you have discretionary income and time on your side. However, nearing retirement, where your duration to compound your savings decreases, you should be more concerned with wealth preservation. At retirement, most individuals lose their primary source of income; or rather exchange it for pension plan distributions. At this stage in your life, you should not be worried about your solvency or whether your investments are going to perform this year. Stability, and hence a low risk appetite, is essential here.
Defining your Risk Tolerance
In contrast, risk tolerance is the amount of risk you are not comfortable being exposed to. This can be viewed as an upper bound on the amount of risk you should have at any given time in your investment portfolio. For example, for diversification purposes, it used to be mandated that mutual funds have no more than 5% exposure to a particular holding. In the ever evolving marketplace, prices tend to fluctuate and some holdings may at times range above the 5% limit. Suppose that an oil stock currently represents 7% of the fund. This would trigger a rebalancing of the existing mutual fund allocation, where at least 2% of the oil stock would be sold off. Effectively, in this case the fund had exceeded its risk tolerance with respect to the oil holding. Many fund and portfolio managers continue to use a similar approach when determining asset allocations. This is to ensure that the fund or portfolio does not become over-exposed to one or a group of particular holdings. By defining a clear risk tolerance, it is easier to understand whether your investments lack sufficient diversification or whether you are holding an undesirable level of risk. It has the added benefit of removing emotion from the equation; holdings are bought and sold according to your portfolio in relation to your risk tolerance, as opposed to your portfolio in relation to your expectation of future growth.
The quantification of risk can be a difficult task, especially if the products comprising your portfolio are complex in nature. Sometimes the types of risks affecting a product are not easily identifiable. Derivatives, for example, are contingent on the underlying security on which it is structured. As such, derivatives can be exposed to various market, credit, operational, and liquidity risks. As a typical retail investor, it is not likely (or recommended) that your portfolio is composed of complex derivatives, so we will focus on the discussion of equities, options, and more specifically, portfolio-level risk.
For equities, some sectors are more hazardous than others. When considering whether to purchase a security for your portfolio, you should able to determine what specific risks the sector is exposed to. You should have an understanding of how the company operates within the sector, and how it differentiates itself from the competition. Mining exploration companies are inherently riskier than grocery chains, and you should acknowledge these distinctions. One way to classify the risk in your portfolio is to sort your securities from high risk to low risk. If you find that the majority of your holdings are high risk according to your classification, it might be worthwhile to reconsider your allocations or the holdings themselves. In addition, if you were to sort your securities by expectation of returns, you should identify whether the level of risk corresponds to the level of expected returns. If you find you are holding “high risk, low reward” securities, you should reassess why they exist in your portfolio. In addition, companies that have been around for decades or centuries tend to have lower probabilities of default. This is one reason why many investors gravitate towards blue-chip stocks such as Pepsico, DuPont, or General Electric. These companies have evolved past their growth phase and generally produce a stable return and dividend. In order to stimulate new growth, many older companies focus their attention on acquisitions. The downside risk is low, since the business model has proven itself in the market, likely through many credit cycles and economic downturn periods. Blue-chip stocks are perceived to be synonymous with safety in this regard. At times, some blue-chip stocks can be classified as value stocks, where the intrinsic value of a company is more than the current market value. Value stocks should be a core component of your portfolio. These are the types of stocks you can typically “set and forget”. Sometimes it can take years for the market value to reach the intrinsic value, so be patient and revaluate your investment thesis for these types of stocks on a periodic basis. Add to these positions if you continue to see value and are comfortable with the exposure. However, for your particular approach to investing, it might be wise to strike a balance between growth and value stocks. Growth stocks tend to be more volatile so be prepared to watch these more closely. Also be willing to acknowledge that markets are reactionary, and growth stocks may never reach the potential returns you might anticipate. It is important to recognize underperformance early, and don’t be afraid to cut your losses if your positions run against you. This is because returns are asymmetric. If a stock is currently at $1, and loses 25% of its value, this corresponds to a stock price of $0.75. Since the stock is now at $0.75, to get back to $1 requires a 1/0.75-1=33% increase of its value. Clearly, the negative asymmetry of returns works against you, and it is better to be cognisant of this fact.
Options are used primarily for hedging or speculation. They reserve the holder the right to purchase an underlying security at a predefined price if certain conditions are met. Options come in many different styles; however each option represents a bundle of 100 underlying securities. For a call option, the price of the underlying must be above the predefined strike (or exercise) price to exercise the option. For a put option, the price of the underlying must be below the predefined strike (or exercise) price to exercise the option. In either case, there are severe risks involved with shorting options. An option seller is paid an upfront premium equal to the price of the option, but inherits the obligation of returning the stock to the buyer if the conditions of the option are met. For example, if you sell a one-month call option on a stock at $100 with a strike price of $120, you would be paid the price of the option upfront. However, if at the end of the month the stock was at $125, you would be obligated to return 100 stocks to the buyer of the option. Investors who short call options generally believe that the stock price won’t exceed the strike price, and hence would earn the premium without any exchange of stock. If an investor shorts too many call options, and stock prices rise dramatically, they could wind up owing a lot of stock to the option buyer. In other words, you should be careful when ‘naked’ selling options. A common options strategy that requires selling call options is a covered call. Covered calls are a strategy that longs the underlying asset, and shorts the associated call option. This is beneficial in a few ways. First, you will earn the premium from shorting the call option; second, you will earn any appreciation on the underlying asset if the price is below the strike price of the call option; and third, if the asset price is above the strike price of the call option, you already own the asset when you are obligated to exchange it at expiry. Just make sure that for each call option you sell, you purchase 100 units of the asset, or else you could owe more than you have available in your portfolio at expiry. The downside of a covered call strategy is exhibited when the asset depreciates in value. Since the option is not exercised, you still own the stock, of which the market value is lower than the time you purchased it. In this case your profit is the option premium less the market loss from your assets.
In any event, the importance of understanding and defining your risk limits are essential for generating and preserving wealth. Many retail investors enter transactions without regard to the potential risks that are elicited, and in some cases are adversely affected as a result. My attempt here is to present an opinion of risk, and hopefully entice others to be more careful when it comes to purchasing financial products that they have a limited understanding of. Furthermore, by defining and changing your appropriate risk appetite and tolerance, you’ll be more comfortable with knowing your holdings fall within them.
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