Risk is not a simple idea. There is no universally agreed way to measure it. Academics and many market practitioners have taken the easy way out by defining risk narrowly as volatility. In other words, they take the highest and lowest price over a period and define risk as the width of that range of prices. So, if a stock fluctuates only 20 per cent in a year, it is said to be less risky than one that fluctuates 50 per cent in a year. More sophisticated approaches measure volatility relative to the overall market benchmark or index. However, the general idea is the same.
This is the easy way out, adopted because it is easily measured. However, there are those who maintain that this definition of risk is too narrow. Indeed, it is not the definition that typical private investors have in mind when they use the term risk. When typical private investors think about risk, they are apprehensive about two possibilities:
- They are afraid that the price will go down. They do not see a rise in prices as a risk, but as a reward. So, it is only downward volatility that the typical investor sees as risk, not the full range from high to low in a period.
- They are afraid that the company will fail and the entire investment will be lost. This is simply an extreme example of the first fear, but it is different in an important way. The typical investor knows that an investment in a failed company is a total and permanent loss. However, a falling stock price is less worrying, they think, because it may recover if they wait long enough.
In reality it is more complicated than that. Risk can be divided into many types, depending on what drives the possibility of loss. These types of risk can be divided into four groups:
1. MARKET RISK
This is the risk associated with the overall market, quite apart from the fortunes of any one company. The prices of all stocks will be affected by general market sentiment. An old saying on Wall Street is to the effect that all ships rise and fall with the tide. Thus, in a strong market, the stocks of sound companies will tend to rise in price more than they would in a weak market. Likewise, in a weak market, stocks of weak businesses will tend to fall further than they will in a strong market. Market risk cannot be fully managed by diversification, because all stocks are affected to some extent. Rather, it is managed by varying the proportion of capital that is invested in stocks or held in a cash reserve.
2. SPECIFIC RISK
This is the risk associated with individual stocks. No matter how good the economy or business conditions are, misfortunes of all kinds can affect an individual company. In the worst case it may go bankrupt. In less spectacular terms, its earnings may fall, or it may even make losses, while the general run of companies are prospering.
Specific risk is managed in three primary ways:
- By selecting investments with a good probability of appreciating in value over time. Aspects of this relate to the conceptual models used to identify opportunities, the time frame over which we invest and the type of stock we invest in.
- By spreading our capital over a number of stocks, or as it is known in investment jargon, through ‘diversification’.
- By limiting the proportion of our capital that is risked in any one stock or, as it is known in investment jargon, through ‘position sizing’.
3. FINANCIAL RISK
This is the risk associated with borrowing money to invest. This can be the obvious sort of leverage, by giving a financial institution security over another asset, such as real estate, or over the stocks purchased with the loan (often called a ‘margin loan’).
It can also manifest itself in another variation of financial risk which operates through the leverage available on derivative securities such as futures, options, warrants, contracts for difference (CFDs) and installment receipts, which involve buying on margin or undertaking to pay more at a later date.
In all these situations, small changes in the value of an investment can result in large gains or equally large losses. In many cases it is possible to lose more than the initial investment.
The other important aspect of financial risk is the level of debt held in those companies that are being considered for investment. This is usually measured using a ratio called ‘debt to equity’. It is simply the total debt in the business as a percentage of the total stockholders’ equity in the business. We have recently seen large losses by stockholders in a number of major companies and property groups. This followed directly from the debt binge through to 2007.
It has hammered home to me the lesson that had moved from the front of my mind since the same thing happened in the 1980s. It should not be forgotten again, lest we be taught an expensive lesson by the market next time. I have now made it an explicit part of my investment plan to check the level of debt in a company before deciding whether to build a position in it.
Financial risk destroys businesses and investors when conditions turn down and they are unable to meet debt servicing charges or debt repayment schedules. There may also be difficulty in refinancing maturing debt, because lenders are unwilling to lend again or lend only at increased interest rates. In the worst case, businesses may fail and are passed into the hands of liquidators. Investors may find that they are unable to meet margin calls and either lose heavily or fall into bankruptcy.
4. LIQUIDITY RISK
This is the risk associated with the ability to quickly move into or out of an investment. Stocks are generally liquid investments, because there is a stock market on which prices are quoted continuously by buyers and sellers.
Nevertheless, some stocks are easier to buy and sell, especially in significant parcels, than others. We may decide to sell, but find that there are not enough buyers available with which to deal in the volume of a stock that we wish to sell.
The liquidity of a company is not an absolute. One measure of liquidity is the number of shares and the value of a company’s stock traded each day. The problem is that investors come in all sizes, from a small private investor to a giant fund. What is liquid for one investor may not be for another. I have found personally that, as my capital has grown over the years, there are many more companies where I am too big for the market in their stock. In other words, liquidity is in the eye of the beholder.
Nor is liquidity only a function of the size of the company, usually measured in the industry by its market capitalisation. Market capitalisation is a jargon term meaning the value of the total number of shares issued by the company multiplied by its current share price. However, some big companies and many smaller ones may have a situation in which a small number of stockholders own a large proportion of the issued stock and it rarely trades in any appreciable volume. Here liquidity relates to the ownership structure of the company.