Risk. How would you define it? Maybe as a board game made by Hasbro (HAS), in which players vie against each other for world domination. Or maybe you consider risk the possibility that something bad might happen. Although the board game is entertaining, let’s stick with the second definition. Now that we know what it is, how do we describe it? After pouring a fresh cup of coffee, what is the risk that you will burn your tongue if you immediately take a sip? What if I told you that this risk is 10? You would look at me as if I had two heads! (The risk is 10!?) That’s because 10 doesn’t mean anything. Risk is not a single number. Although a number of people in the world of finance define risk as standard deviation or variance, we believe that is not a representative definition. Ultimately, in terms of making an investment, risk is the permanent impairment of your capital, which cannot possibly be measured by one single number.
Volatility is Not Risk
The chart below shows a measure of volatility of the S&P 500 (blue line) along with returns on the same index (red line) from January 1990 to June 2012. We use the Chicago Board Options Exchange Volatility Index (VIX) as our volatility line. (Check out “The VIX and What it Tells Investors About Market Volatility” to learn more about this index). Looking at the graph we can see that as the market dips, the VIX spikes. If you subscribe to the belief that volatility equals risk, then you would have bought and sold at precisely the wrong times over the period of 1990 to June 2012. High volatility, it would seem, creates opportunities for investors to get in at attractive prices, rather than indicate that excessive risk is present. This brings to mind a quote from Berkshire Hathaway (BRK/B) CEO Warren Buffett, “Look at market fluctuation as your friend rather than your enemy; profit from folly rather than participate in it.”
Source: Yahoo! Finance
Systematic and Nonsystematic Risk
There are two general types of investment risk: systematic and nonsystematic. Systematic risk cannot be avoided and is inherent in the overall market. It is non-diversifiable because it includes general risk factors that affect the market as a whole. Examples include a change in interest rates, inflation, economic cycles, political uncertainty, and widespread natural disasters.
Nonsystematic risk is local or limited to a particular asset or industry that doesn’t affect assets outside of that asset class. Examples include a recall of a drug, major oil spill, or a shortage of cotton. This type of risk can be diversified away by choosing assets that have a low correlation to each other.
What to Consider
Clearly, risk is not a single number and is better approached as a multifaceted concept. There is no magic formula that says if you look at X, Y, and Z then you will not lose money on your investment. Based on our previous definition of risk as the permanent impairment of your capital, there are however three general factors to examine in order to minimize overall risk: valuation, business, and financing risk – all of which can be monitored by using Value Line reports.
Valuation risk is the risk that you may not pay a fair price for a security, and relevant information regarding this risk can be found in the array on our company pages. Business risk is the risk that there may be fundamental problems with the security -- maybe management is not competent or the company’s main source of revenue will not be reliable in the future due to new technology. Either way, information on this type of risk can be found in the analyst’s commentary. Lastly, financing risk looks at the leverage (amount of debt) of a company. Too much leverage and the interest payments could become burdensome; meaning the company probably won’t stick around in its present state much longer. This type of risk can be monitored using the capital structure and financial position boxes.
Now, you may notice these three factors have a value investing tilt to them. This is because the basic concept of value investing is to limit losses. For growth investors (those more interested in companies exhibiting above-average growth regardless of their valuation), it may be more useful to place additional weight on the annual rates box versus the valuation numbers. For income-oriented investors, looking at the quarterly dividends box and the dividend yield will help to determine what kind of payout you can expect.
Regardless of your motivation or investment strategy, it is important to keep in mind all of the risks involved and to remember, focusing on a single metric is likely not the best course of action.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.