The Investment Scientist

Taking Investment Risks

Posted on: September 30, 2010

Investment Risks

Risk taking is an integral part of investing, yet most investors are blissfully unaware of the risks they are taking, let alone managing them well. In this post, you will quickly learn the good, the bad, and the ugly of investment risks.

Nine Types of Risks

Idiosyncratic risk is defined as risk that is specific to a particular company. This type of risk can be eliminated simply by holding a well-diversified portfolio; therefore, taking this kind of risk is not compensated by the capital market. Examples of taking idiosyncratic risk include investing in individual stocks and buying annuities as investment.

Systematic market risk (or beta risk) is defined as the risk in equity that cannot be diversified away; this risk is compensated by the so-called equity risk premium. A manifestation of this risk premium is that stocks have higher returns than bonds over the long run. If you invest in the S&P 500 index fund, you are taking systematic market risk.

Small cap stocks are more volatile than large cap stocks; therefore, taking small cap risk is rewarded with a small cap premium. A manifestation of this risk premium is that small cap stocks have higher returns than large cap stocks over the long run. Unfortunately, most investors shun small cap stocks. Not this advisor.

Value risk is because value stocks are perceived to be more risky than growth stocks; therefore, investing in value stocks earns you a value premium in the form of higher returns than growth stocks over the long run. Most investors shun value stocks since they lack the glamour of growth stocks. Again, not this advisor.

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Duration risk is defined as the sensitivity of bond value to the interest rate. Take a 30-year zero-coupon bond, for example; a 1% rise in the interest rate from 4% to 5% would cut the bond value by 25%. This is duration risk in action! According to Fama and French research, duration risk is not well-compensated.

Credit risk is defined as the probability of default by bond issuers. Credit risk is compensated by a default risk premium in the form of higher yields on lower quality bonds. However, earning these high yields is akin to taking a higher wage to work in a more dangerous coal mine. It is fine until something really bad happen.

Inflation risk is the risk you are taking when you save all your money in the bank or put it under a mattress. You may think you are not taking any risk, but inflation is nipping away at your wealth.

Agency risk is the risk you are taking when you invest through an agent, but the agent’s interest is not aligned with yours. When you hire a financial advisor from a big Wall Street firm to manage your wealth, you are taking unmitigated agency risk, and you don’t earn higher returns for taking this risk. Quite the opposite, usually you earn much lower returns.

Asymmetric information risk is the risk associated with knowing less than your counterparty in an investment transaction. When you invest in a hedge fund or a private equity you don’t know much about, you are taking asymmetric information risk. Taking this risk almost always leads to losses.

Know The Good, The Bad and The Ugly

The good: beta risk, small cap risk, and value risk

The bad: idiosyncratic risk, duration risk, credit risk, and inflation risk

The ugly: agency risk and asymmetric information risk

What risks you are taking? Schedule my complimentary second opinion review and let’s find out together

Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.

1 Response to "Taking Investment Risks"

EXCELLENT POST!!! VERY INFRMATIVE!! my latest blog post focuses on hedge funds, I should have mentioned Asymmetric information risk in this post. It is part II of a four part series, so I will be mentioning it in an upcoming post.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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