When you hear the word, “risk”, what kind of image does that bring up? People often associate the word risk with an accident, loss, and damage. Basically, something negative that you want to avoid. Risk in investment is the same: something that you want to avoid.
According to Investopedia, risk is a financial term referring to the possibility of having an outcome or investor’s actual gain different from what was originally expected. This includes the chance of losing one’s original investment.
This brings us to the question everyone wants to know: Is there a bulletproof way of avoiding any and all risks? Unfortunately, no. However, one can certainly minimize risk by first studying the kind of risks you would face when investing and planning accordingly.
In this article we will look at the following: 2 types of risks and 3 management tips.
Investors face all sorts of risks in the course of their investments. As the market evolves to be more complex, so is the complexity of risks. As such, there are multiple ways of categorizing risks, depending on the characteristics one places the focus. Today, we want to take a look at one of them: systematic risk vs. unsystematic risk.
A risk is systematic if the probability of loss associated with the entire market or the market segment. In other words, the value of my portfolio is influenced by the volatility of the entire market. This risk is associated with macroeconomic events such as war, extreme foreign exchange fluctuations, inflation, as well as political or economic events of the time. As the scale of these events is big enough to influence the entire market, it is often difficult to avoid. In the past, it was considered a difficult task to predict these risks, however, modern technology has made it easier than ever. You can now google country risk, currency risk, and inflation risk. Also, having your ears to the ground can also help you gauge the systematic risks.
Synonym of systematic risk
#undiversifiable risk #volatility #market risk
Unsystematic risk refers to risks associated with a specific industry or company. For instance, you can think of risk from labor union conflict, strikes, or legal issues of a company. Let’s suppose you invested in company A and the labor union decided to go on strike for a month. This can negatively affect the revenue company A generates in that quarter. However, industries or companies unrelated to company A will be unaffected.
Synonym of unsystematic risk
#diversifiable risk #non-systematic risk #residual risk #specific risk
No investment has zero risks. The second best option will be to minimize the risks. Therefore, we need to find out all potential risks ahead of time to minimize or prevent the consequential loss. The umbrella term that refers to all these activities is called risk management.
In order to efficiently manage risks, one needs to know the following three principle concepts: volatility, MDD( Maximum Drawdown), and diversification.
Definition of volatility
Simply speaking, volatility is a degree of price movement away from its average. When your asset shows high volatility, the price moves up and down by a lot in a given time period.
Naturally, volatility is closely related to portfolio stability. For instance, if stock A has volatility of 5 and B has a volatility of 10, then A is more stable than B.
While volatility is closely related to risk, it is also related to gains. No volatility means no gains, because the price experienced no change at all! If the volatility is pointing upward, that means that the volatility of 10 is likely to generate a higher return than the one with the volatility of 5.
You may already noticed by now, but the direction of the volatility is really important. Theoretically speaking, two stocks would show the same volatility if the price of one goes up by $5 and the other falls by $5.
Definition of Drawdown
Investment repeats gains and losses. Drawdown represents the difference in value between the peak and trough in a given time period. It is often measured in percentage.
Definition of MDD (Maximum Drawdown)
MDD (Maximum Drawdown) refers to the greatest loss one experiences in a given period. MDD is a metric used to evaluate the risk level of funds. Drawdowns are measured in percentage and the higher percentage (highest being 100%) represents the greatest risk.
Importance of MDD
Why do you need to stop the loss? When you experience a huge loss, that means you need to perform exceedingly good to make up the loss and come up even. What does that mean? There is a stock that used to be worth $100 recently went down by 50% and became $50. Since I lost 50%, do I need to recover 50%? No. You now need to perform 100% in order to recover the original value of $100.
Therefore, knowing the MDD is important for risk management. Of course, MDD does not tell you everything. You can gauge what the maximum loss would be, however, it does not tell you the speed or the frequency at which the particular asset will recover from the trough.
The Formula for MDD(Maximum Drawn)
The formula for MDD(Maximum Drawdown)
MDD=(Trough Value – Peak Value) ÷ Peak Value
You subtract the peak value from the trough value. Afterward, you divide the outcome with the same peak value. The figure will always come out with a negative number.
Definition of Diversification
Diversification refers to the strategy where investors spread the capital across various financial instruments and industries that would react differently to a given event. Diversification is a good method to minimize loss from both a systematic and unsystematic risk event.
Asset Correlation Asset correlation plays an important role in diversification. For two assets to behave differently to a given event, they would likely have differing corollaries. As the core of diversification is to buffer losses experienced by one asset by gains from another asset. Therefore, comprising one’s portfolio with assets with many pairs with a small correlation is the key.
Weight also plays a defining role in deciding portfolio performance. Two portfolios, composed of the same kind of assets can show different performance due to the proportion, or the weight, of those assets.
Let’s suppose portfolio #1 has 20% of A and 80% of B. Portfolio #2 has 50% of A and 50% of B. During a given period, B performed better than A. Then, portfolio #1 will show better performance than portfolio #2.
Good applications of diversification
Index funds and ETFs are investment instruments built upon the principle of diversification. They are funds designed to mirror indices such as the S&P 500. The S&P 500 is an index that tracks the stock prices of the top 500 US companies. When you are investing in an index fund of S&P 500, this means your money will be distributed to stocks of the 500 companies included in the index, in the same weight as they are proportioned in the index. Your money will obviously be spread across numerous industries as it would be invested in all the 500 companies. This is a prime example of diversification.
Diversification does not aim to beat the market. Rather, it aims to minimize the risk and to build a stable portfolio that can withstand all weathers. If you know a unicorn stock, you could select and focus. If you don’t, then diversification could be your best choice.
Warren Buffet and Diversification
Warren Buffet is a famous advocate for passive investment management. The following is his quote from Gurufocus, on the topic of diversification.
“I have two views on diversification. If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. (…)”
“ If it’s your game, diversification doesn’t make sense. It’s crazy to put money into your 20th choice rather than your first choice. ‘Lebron James analogy.’ If you have Lebron James on your team, don’t take him out of the game just to make room for someone else. (…)”
The bottom line is, you cannot afford to overlook risk management if you want to build an all-weather portfolio. I hope we delivered the message, as well as useful insights on risks and their management.
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