Investing 101: Why Risk Rules the Markets

The following is an excerpt from our ebook, “A Minimalist’s Guide to Financial Markets,” which you can download by clicking here.

Risk and return are closely related.

Everything else being equal, the riskier company will cost less because there is less certainty of getting a return on your investment. People are willing to pay less for the company, and if it does pay off, it will do so on a larger scale than a less risky company.

The Capital Markets Have Rewarded Long-Term Investors

Everybody views risk differently. What seems like a big risk for one person may be inconsequential to somebody else.

So, instead of focusing on an absolute definition of risk, we can simply agree on this rule: More risk does not mean more return, but to get more return you need to take more risk.

Not all risk is created equal, and you only get paid for taking on certain types of risk. This might seem self evident, but it’s worth saying: When you invest, you want to take on good risk and avoid bad risk.

The Two Categories of Risk (and How to Avoid Bad Risk)

Risk has two categories: systematic (a.k.a. “the good kind”) and unsystematic (“the bad kind”).

Unsystematic risk is tied to a specific company or small subsection of the market. The easiest example is the risk that a company’s CEO could get hit by a bus at any moment (the CEO would have to be really bad for this to be a good thing). It’s a risk for the company, but every company carries that same risk, so the market doesn’t compensate you for taking it on.

You can nearly cancel unsystematic risk out by investing your money into a number of companies or sections of the market – known as “diversification.” Diversifying requires money and planning, but it’s worth it.

A truly diversified portfolio does more than just reduce the volatility in your investments. It represents the mixed landscape of stock markets around the world.

Owning 30 to 50 stocks may help level out some of the day-to-day fluctuations in the market, but that represents a sliver of the market. In the United States alone, as of December 2015, over 3,600 stocks were being publically traded. Globally, the number was over 12,000[1].

You don’t need to own every company, but the closer you can come (and you can come pretty close), the better. This may sound complicated, but — thanks to index mutual funds and ETFs — it’s actually pretty easy, and you don’t have to be a multimillionaire to do it.

Systematic risks are trickier and more pervasive. Systematic risks are the inherent risks of investing – in short, any risk that’s not unsystematic is systematic. Several types of risk fall under the umbrella of systematic risk. Some are good and some are bad. You want to take systematic risks with positive expected returns, which is a fancy way of saying, “Take risks the market pays you for taking.”

Have You Considered These Systematic Risks in Your Bond Investments?

Systematic risks in bonds come in two forms: maturity and credit risk.

Maturity risk – This is sometimes referred to as “term risk.” Maturity risk is based on how long a company or government plans to borrow money. The longer money is borrowed, the higher the interest rate since there is more time for something to go wrong. It’s the same reason 15-year mortgages carry lower interest rates than 30-year mortgages – the bank takes on more maturity risk with the 30-year mortgage.

Credit risk – Credit risk is a risk you take the moment you loan your money. You loan your money knowing there’s a chance you won’t receive the payments you’ve been promised. Like our previous example of the two individuals seeking a bank loan, the lower the likelihood of being paid back, the higher the credit risk or interest rate.

Have You Considered These Systematic Risks in Your Stock Investments?

On the equity side, systematic risks get a little more abstract, with four main types:: market, size, value and profitability.

Market risk – Market risk comes from the fact that stocks are riskier than bonds. Bonds come with promised fixed cash flows, while stocks depend on a company’s performance. A stock represents a tiny ownership stake in a company. As a “business owner,” the success or failure of your investment depends on how well the company does against what the market expects of it.

This carries a great deal of uncertainty. As an investor, you need an upside to make it worth your time and money to take on that kind of uncertainty. The upside you’re looking for is a low price with room for the stock to go up and reap positive returns.

Size risk – Smaller companies tend to be riskier than larger companies

A good way to think about size risk is to think once again in terms of a bank giving out loans. The larger company is like the person with the higher credit score – the bank sees a greater chance of being paid back, so they give the larger company a lower interest rate.

The same principle works in stocks. Smaller companies tend to be more unstable and carry less certainty about their cash flows. Investors will take on that uncertainty, but only with the promise of higher returns.

Value and profitability risk – Value risk and profitability risk are not the same, but it’s easier to understand them as a unit as both could be considered price risks.

Financial markets don’t care what accountants think a company is worth. Accountants base a company’s worth on the combined value of everything they own while the markets base it on how much they think the company will make in the future.

When these numbers diverge, it tells us something about company’s value risk. If the accountants price it higher than the market, we know the markets consider the company risky for some reason. We don’t necessarily know why or what the specific source of the risk is – maybe they don’t trust the CEO, maybe they don’t see a profitable business model – we just know the market doesn’t like the company all that much. Whatever the specific reason for this dislike, on average, this is a risk with a positive expected return.

Profitability risk is the same. Low market value relative to profits means the markets don’t like the it for some reason. Investors expect a higher return for investing in these companies.

Click here to download the ebook “A Minimalist’s Guide to Understanding Financial Markets.”

[1] Data courtesy of Dimensional Fund Advisors.

 

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