MOST people get scared once they hear the word "risk" and seemingly involuntarily bristle whenever the word is mentioned. Rightfully so, such persons cannot be blamed for their aversion, as they may have been victims of the materialization of an adverse event, like the financial meltdown of the 1990s or the implosion of recent UFO's (Unregistered Financial Organisations). However, the danger is that we forego valuable investment opportunities. The truth is that there is risk in everything. There is risk in putting your money on deposit in the bank or in crossing the street. The fact is, each action or investment has different types of risks in different proportions. The solution is to understand the risks at hand and mitigate them as best as possible. This article will address two types of risk: credit risk and price risk.
Risk is measured by qualitative and quantitative factors. For example, the most frequent and easy to use measure of credit risk is a "credit rating" that is produced by credit rating agencies, such as Standard & Poor's (S&P) and Moody's. Credit risk describes the likelihood that the issuer of the security underlying your investment will default on its payment. Another helpful measure is the Sharpe Ratio. The Sharpe Ratio measures how much extra return you get on a particular investment per additional unit of risk you take.
Price risk is another type of risk that is frequently considered by investors. Price risk describes the likelihood that the price of the investment purchased will move in an adverse direction. For long investors, this is the risk that the price will fall, for short investors, this is the risk that the price will rise. It is also gauged by statistical measures such as the standard deviation, beta (in the case of a stock) and the price value of a basis point (in the case of a bond)
However, despite the statistics, the interpretation of risk by an investor is relative and depends on how comfortable the investor feels about the probability of the materialisation of the worst case scenario. Indeed the emergence and subsequent death of the UFO's both locally and internationally indicate that many investors did not weigh the risk of default very heavily. High returns were the primary objective of these investors and as such, the risks associated with the investments were not interpreted to be serious. Each investor has different objectives and their risk appetites are ultimately a product of these objectives.
The Sterling Report series has addressed credit risk as arguably one of the most important types of risk that characterises an investment. Credit risk is determined by the financial and strategic position of the issuer, among other factors such as the regulatory, political, economic and social environment. We have referred to the use of "credit ratings" issued by the rating agencies as a guide for assessing the creditworthiness of an issuer. We've likened credit ratings to grades in school. The higher the credit rating, the better the performance and the lower the credit risk of the issuer. Eg S&P has assigned the Government of California a credit rating of A while the Government of Venezuela is rated B. Debt issued by the Government of California is therefore safer than the debt issued by the Government of Venezuela.
Credit risk is particularly relevant to bonds because the bondholder is looking for a consistent stream of income. However, price risk is usually more heavily weighted by stockholders. Stockholders, unlike bondholders, are not looking for a fixed stream of income, just growth in the stock price. Hence the emphasis on price risk. The historical price trends and volumes traded of a stock, are therefore, some of the most common indicators used by a stock investor.
That is not to say that price risk is not relevant to bonds, and credit risk is not relevant to stockholders. Indeed, most bondholders aim to realise capital gains and most stockholders need to ensure the solvency and liquidity of the companies in which they are invested. However, some risks are more heavily weighted than others depending on the objectives of the investor. A bond investor with capital preservation as his major objective is usually less concerned with the room for capital appreciation. Rather, they want to maintain the principal of their investment by avoiding price declines and credit defaults. Profit seeking stockholders may be willing to buy the stock of very volatile companies if there is an opportunity for a large capital gain.
Additionally, some instruments may have more credit risk or price risk than others. For example, a US Government bond has less credit risk than a Government of Jamaica bond. Historically, large cap stocks have been found to exhibit less price volatility than small cap stocks, although current market volatility is putting "historical trends" to the test. As you can see, risk also varies within asset classes.
There is no 100 per cent elimination of risk. All investments carry risk. We advocate what has become known as "calculated risk". This simply means that investors should understand the risks at hand and identify the probability of the worst case scenario prior to placing an investment. Therefore investors should "calculate the risk" as objectively as possible.
Pamela Lewis is Vice President, Investments and Client Services at Sterling Asset Management Ltd. Sterling provides financial and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: email@example.com or visit our website at www.sterling.com.jm