KnowRisk is focusing on the closely interconnected concepts of risk and volatility this month. Risks come in many different varieties, with some affecting only certain types of investments, and others affecting nearly all investments across many asset classes. Creating an accurate picture of the risk level and the volatility that is inherent in any investment is a vital part of the investment process. In this article, we will define the different types of risk, examine the effect that each can have on different investments, and consider the best ways in which investors can mitigate these risks within their portfolios. By the end of this article, you should have a much better understanding of the way that risk affects your investments, and what you and your consultant can do to minimize the effect that those risks have on the long-term health of your portfolio.
Types of Risk
Industry/Company Risk — This risk rates the potential for any given security to decline due to negative developments within a specific company or industry.
Market Risk — This risk is particularly important when evaluating stocks, as general market fluctuations tend to cause these investments to fluctuate more than bonds and other asset classes, leading to potentially greater risk over short time horizons.
Credit Risk — This bond-specific risk measures the potential for a bond issuer to become unable to make timely payments of principal and interest; the value of bonds can also decrease should the issuer encounter financial difficulties or see its credit rating decline.
Interest Rate Risk — While this risk is greater due to the price volatility associated with longer-maturity bonds, all bonds tend to rise in value as interest rates fall, and vice-versa.
Reinvestment Risk — This risk can affect bonds with “call” provisions, in situations where falling interest rates cause the issuer to call in those bonds prior to their maturity. The risk here is that the investor could then be faced with the problem of having to reinvest the principal in bonds that offer a lower interest rate.
Inflation Risk — If investments do not keep up with the level of inflation (a rise in the overall price of goods and services), an investor’s money will purchase less in the future than it did in the past.
Currency Risk — As we discussed in last month’s KnowRisk, currency risk affects those who invest in foreign securities. As foreign exchange rates fluctuate constantly based on the supply of and demand for each country’s currency, the returns that local investors receive on a given investment are often quite different from those seen by U.S. investors, even though both are investing in the same security.
Political/Economic Risk — This risk broadly encompasses the potential for political and economic developments within a given country to impact investments in that country.
Market-Timing Risk — Investors who attempt to “time” the market (that is, to invest when they believe that the market is on an upswing, or removing investments when they believe the market is in a downturn) risk jumping into markets during the worst times, and/or not participating in markets during the best times.
Mitigating Industry/Company Risk: Stock Diversification
No matter how thorough the research that an investor or money manager puts in before purchasing a position in a company, there is always the risk that a given stock may fall in price due to non-market-related factors (such as poor company management). This is why diversification is such an important factor in creating a well-structured investment program. Given that company/security risk is simply the excess risk that investment in any given stock entails in excess of the risk level of the overall market (and that that risk is not always rewarded with higher returns), the best way for investors to mitigate this risk is by investing in a larger number of securities, across a number of industries.
In practical terms, the easiest way for most investors to reduce company/industry risk in their portfolios is by investing in mutual funds. Unlike individual investors, mutual funds command millions of dollars in assets, and therefore can afford to take positions in hundreds of stocks, thereby reducing the overall company/industry risk level. Individual investors rarely enjoy these economies of scale.
By including more securities in a portfolio, investors can reduce the level of company/industry-specific risk to which they are exposed. And while this is a particularly important consideration when investing in stocks, it also applies to investments in other asset classes. The graph above provides an illustration of how an investor who holds more than one hundred different stocks can reduce his company risk to a very low level.
Market Risk Remains. Unfortunately, even a well-diversified portfolio cannot remove the issue of market risk. Even if an investor holds every stock that’s available in a market, and is exposed to very little company-specific risk, he would still be exposed to the risk that the entire market will experience a decline in price. Some investors can mitigate this risk by investing in products that hedge against it. [1]
Risk Tolerance Spectrum
The trade off between returns and risk is fairly straightforward: as a rule, investors who desire high long-term returns must be willing to accept the high levels of volatility that are characteristic of the asset classes that produce such returns. On the other hand, if an investor is interested in lower levels of risk, he should be prepared to accept lower return levels on his investments.
In this example, we are defining risk as the fluctuations in returns between one period and the next. The risk levels associated with different asset classes vary widely: lower-risk investments, such as “cash equivalents” (a class including Treasury bills and certificates of deposit) have historically averaged modest long-term returns. Higher-risk investments (which include large-cap, small-cap, and international stocks) have historically averaged higher returns, but with greater volatility (fluctuations in value).
One of the first steps involved in developing an investment plan is determining which is more important: the stability of returns or long-term investment performance.
For example, as the above chart illustrates, cash equivalents like certificates of deposit (which are insured and offer a fixed rate of return), feature the lowest available level of risk, while also promising low levels of return. Slightly higher up the risk spectrum, government bonds (which are guaranteed by the full faith and credit of the U.S. government as to timely payment of principal and interest) promise slightly higher, but still low levels of risk and comparatively low returns. In considering stocks, it is worth noting that a large-cap domestic portfolio offers lower risk than international and small-cap stocks, though also the potential for lower returns. As noted above, international investments incur special currency risks, but also can be exposed to the potential for economic and political risks, foreign taxation, liquidity risks, and risk related to differences in accounting and financial practices among nations. For all of these reasons, domestic investors rightly expect the potential for higher returns to reward the increased level of risk they incur.
Asset Class Returns 1926-2007
As we’ve discussed, all assets involve some inherent degree of risk. However, some asset classes are considered more volatile (and therefore riskier) than others. One of the best ways to evaluate risk for an asset class is to look at that class’ historical returns. By gauging the highest and lowest returns that an asset class has experienced over a long-term historical horizon, investors may gain valuable insight into its demonstrated risk profile.
This graph illustrates the range of annual returns over the period 1926 through 2007 for five asset classes commonly considered during the asset allocation process.
As we saw in the section above, the safest, most stable asset class has historically been Treasury bills — that stability is reflected here by their comparatively narrow range of historical returns. Note that both intermediate and long-term government bonds have experienced a wider range of returns than Treasury bills; this reflects the fact that longer-maturity bonds are more interest-rate sensitive, which tends to result in greater price volatility over time.
As expected, the asset classes that have the greatest range of returns/volatility historically are also the asset classes that have seen the highest compound annual returns: stocks, including both large- and small-cap equities. As expected, small-cap stocks are demonstrably more volatile than large-cap stocks, as the class is subject to significant price fluctuations and business risks, and are comparatively thinly traded. [2]
Reduction of Risk Over Time
In assessing the amount of risk, or volatility, that any investor is prepared to assume, one important consideration is the fact that the range of returns in a given asset class appears less volatile when considered over a longer holding period. This is a result of the fact that, over the long term, periods of high and low returns tend to offset each other. And with the passage of time, this offsetting effect results in the overall return dispersion gravitating toward the average of that class’ returns. In other words, while a given year’s returns may fluctuate widely, holding an asset for a longer period appears to result in decreased volatility.
Consider the graph below, which illustrates the range of compound annual returns for stocks, bonds, and cash over one-, five-, and twenty-year holding periods.
Take, for example, the large-cap stock asset class. Considered on an annual basis since 1926, the returns on large-company stocks have ranged from a high of 54% to a low of -43%. However, when considered over longer holding periods, the picture changes considerably. For example, the average returns range from 29% to -12% over five-year periods, and between 18% and 3% over 20-year periods. In addition, when considering the worst 20-year holding period for stocks since 1926, stocks still posted a positive 20-year compound annual return.
In conclusion, while stockholders can expect considerable short-term volatility, the risks involved in holding stocks appear to diminish with time. However, it is important to recall that holding stocks over a longer term does not ensure a profitable outcome, and investing in stocks always involves risk, including the possibility of losing some or all of the initial investment. [3]
Stocks, Bonds, Bills, and Inflation: Summary Statistics 1926-2007
The table below represents a quantitative summary of the risk/return tradeoff inherent in investing, which can be defined as the fact that as a rule, the potential return of an asset tends to increase along with the asset’s risk level. The “compound annual return” column reflects the annual rate of return that a hypothetical investment would have achieved over the entire 82-year period, assuming that the investor reinvested all dividend income back into the investment. The “arithmetic annual return,” represented in the second column, represents a simple, or arithmetic, average of the investment’s individual annual returns over the entire period.
Inflation Risk: Stocks Versus Fixed Income
The table above illustrates the best and worst average inflation-adjusted returns for four asset classes over 20-year rolling periods. The term “rolling period” returns describes a series of overlapping contiguous periods; for example, when examining 20-year rolling periods for annual return data that begins in 1926, the first period is 1926-1945, the second period is 1927-1946, the third is 1928-1947, etc.
Examining this table, we can see that fixed-income asset classes have experienced very modest real (that is, inflation-adjusted) 20-year rolling returns: 2.9% for Treasury bills, and 8.6% for government bonds; in addition, these classes have each shown negative real returns over certain 20-year periods. On the other hand, stocks have historically exhibited positive real returns over 20-year periods. Historically, then, investors would have been less likely to lose purchasing power over the long run by investing in either large-cap or small-cap stocks instead of fixed-income investments. [5]
Fixed Income Maturity Risk
When interest rates fall, bond prices rise, and vice versa. The amount of fluctuation when interest rates move is called maturity risk. The longer a bond’s maturity, the greater the maturity risk.
For purposes of this table, each annual period from 1970 through 2007 was categorized either as a year in which yields rose, or a year in which yields fell. Then, we averaged the price changes for all positive years, and separately averaged the price changes for all negative years. The effect of this calculation was to isolate price change from total return, in order to emphasize the effect of maturity on interest rate sensitivity.
While shorter maturity bonds have been relatively insensitive to movements in interest rates (dipping an average of -1.3% in negative years, and gaining an average 1.6% in positive years), bonds with longer maturities have been far more sensitive (dropping an average of -7.7% when interest rates have risen and gaining an average of 9.2% when interest rates have fallen). [6]
Liquidity Risk
As noted above, “liquidity risk” refers to situations in which there is insufficient demand for a security. When this happens, that security may be difficult to sell on the open market, and its price can drop significantly.
We looked over the average trading volume for all large-cap, mid-cap and small-cap stocks, and calculated the average trading volume of each group. The average trading volume of the large-cap stock category was 4.10 million, while mid-cap stocks averaged 1.70 million, and small-cap stocks averaged 0.33 million.
These numbers demonstrate the fact that, as a rule, large-cap stocks are less subject to liquidity risks than are mid-cap stocks, which are similarly less subject to liquidity risks than are small-caps. This makes intuitive sense: after all, given that large-cap stocks are held by a wide range of shareholders and tend to be heavily traded, investors are likely to be able to sell their position at their desired price. Conversely, small-cap stocks tend to be less widely held and more lightly traded, and may not be well-known by the public. These factors tend to make it more difficult for investors to sell small-cap shares at the prices they seek. In fact, in situations where prices are declining, investors may not be able to sell their shares at all.
Some historical performance results show that the average rate of return for stocks has been higher for small companies than for large. There may be a greater potential for growth with small companies, but investors should be aware that there is also a greater risk of loss.
Market-Timing Risk
As we noted at the beginning of this article, market-timing risk (which is incurred by investors who attempt to time their purchases and sales of securities based on predictions about near-term market movements) runs the risk of missing periods of exceptional returns. This practice may have a negative effect on a sound investment strategy.
Over the period examined in this chart, it is clear that missing the one best-performing month during a given year would have vastly reduced returns for a hypothetical portfolio. Even in years that resulted in negative returns, missing the best month only exaggerated portfolio losses. In five of the 38 years shown (1970, 1978, 1984, 1987, and 1994) otherwise positive returns would have been dragged into negative territory should an investor have missed the best-performing month.
Although successful market timing may improve portfolio performance, it is very difficult to time the market consistently. On the other hand, unsuccessful market timing can have a significant negative impact on performance.
In 2002, Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC, located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high-net-worth family offices.