So far we have talked about how the investing industry is built on jargon and technical terms that may have you thinking that making a solid and safe return on your money is best left to the professionals. But remember, knowledge is power. This instalment, and the next few, will break down fundamental concepts so you will have a solid foundation to build upon so that you begin building your portfolio with confidence and understanding. We are going to start with risk and return as it is foundational to investing.
The Concept of Risk and Return
If you think of the world of investing as a vast ocean, the concept of risk and return is the current that guides every wave. Risk is the possibility of losing some or all of your investment, while return is the profit you earn. Different investments carry varying levels of risk and potential return, and understanding this balance is the cornerstone of investing.
Understanding Risk
Risk is an inherent part of investing. It refers to the possibility of losing some or all of your investment. Different types of investments carry varying levels of risk. For example, stocks are generally considered riskier than bonds because their prices can fluctuate significantly in a short period. However, stocks also have the potential for higher returns compared to bonds.
Understanding the types of risks is important in building a diversified portfolio. By diversifying the types of investments in your portfolio, you are often diversifying the types of risk and the overall risk of your entire portfolio.
Types of Risk
1. Market Risk is the risk of investments losing value due to overall market conditions. The global financial crisis of 2008 is an example of market risk.
For example, imagine you owned shares in a diversified portfolio of stocks, including both financial and non-financial companies. Here's how market risk played out during the 2008 crisis:
- Before the Crisis:
- You own $10,000 worth of shares in Citigroup.
- You own $10,000 worth of shares in General Motors.
- You own $10,000 worth of shares in Apple.
- During the Crisis:
- The overall market conditions deteriorate rapidly due to the financial crisis.
- Citigroup's stock price drops by 80%, reducing your investment to $2,000.
- General Motors' stock price drops by 70%, reducing your investment to $3,000.
- While Apple's stock price is not as severely affected, it still drops by 40%, reducing your investment to $6,000.
- Impact on Your Portfolio:
- The total value of your portfolio drops from $30,000 to $11,000, a loss of 63%.
- This significant decline is due to market risk, as the downturn affected the entire market, not just individual companies.
2. Credit Risk: The risk that a bond issuer will default on interest or principal payments.
With the understanding that bonds are just ways that big companies (or governments borrow money) think of a bond like an IOU. A credit risk is essentially how likely or risky it is that a company or a government) can’t pay back that IOU. There are credit rating agencies, like Moodys and Standard & Poor's (S&P), who are responsible for assessing how risky a bond is based on the company’s (or government’s) ability to pay back the debt. Bonds are rated from AAA (highest credit quality) to D (they will default). Everything above a BBB is considered investment grade, and everything below a BB is non-investment grade (more commonly known as junk bonds).
Downgrading a bond is when the rating agencies determine that the likelihood of the company (or government) paying back the loan has become riskier.
An example of this is the Enron bond default in 2001. Initially Enron’s bonds were rated BBB+. However, as the fraudulent accounting practices of Enron that eventually led to the company’s bankruptcy came to light, these bonds were downgraded. i.e. getting your return on investment became riskier.
3. Inflation Risk: The risk that the purchasing power of your investment returns will be eroded by inflation.Inflation is basically the rate at which the general level of prices for goods and services increases. It is why the same chocolate bar that now costs $2.50 used to cost $0.50. Inflation leads to a decrease in the purchasing power of a currency. I.e. A dollar in 1970 could buy you more than a dollar in 2024. Inflation is typically measured by indices such as the Consumer Price Index (CPI) or the Producer Price Index (PPI).
Inflation risk is why you will lose money if you keep your dollar bills stuffed in a shoebox under your bed instead of investing them in the market. However, this can even happen if you invest your money too conservatively.
For example, let’s say that you have $10,000 and put it in a very safe and low-risk traditional savings account that offers you a return of 1%, and you decide to leave this money in this account for five years. And, let’s say that during this period, the rate of inflation is 3%.
At a 1% annual interest rate, your savings account grows as follows:
- After 1 year: $10,100
- After 2 years: $10,201
- After 3 years: $10,303.01
- After 4 years: $10,406.04
- After 5 years: $10,510.10
And you might think that you are doing pretty good because you have just made $510.10. But now, let’s factor in inflation.
With inflation, the prices of goods and services increase by an average of 3% each year. So, after 5 years, the cumulative effect of 3% inflation means that what cost $10,000 initially now costs approximately $11,592 (using the formula for compound interest: Future Value = Present Value * (1 + inflation rate) years).
So, over that five-year period, your purchasing power has lost $1,082 ($11,592 - $10,510).
Sometimes, those seemingly “safe” investments are not so safe.
4. Liquidity Risk: The risk of not being able to sell an investment quickly without significantly affecting its price.This basically means that some investments can’t be turned into cash (liquidity) as quickly as others. Real estate is a great example of an investment that carries liquidity risk.
For example, let's say you own a commercial property worth $500,000 and need to sell it quickly to raise cash for a financial emergency or to take advantage of another opportunity.
If there is low demand at that time for that type of property, finding a buyer who is willing to pay the full market value of $500,000 could be challenging. In order to liquidate the asset, you may be forced to accept a below-market offer.
5. Interest Rate Risk: The risk that changes in interest rates will affect the value of your investments, particularly bonds.When you purchase a bond, it will have an interest rate attached to it. This essentially tells you how much you can expect to be paid when the bond matures—meaning when the IOU is due. Side note: the annual interest rate of a bond is referred to as the ‘coupon rate’. I know . . . jargon!
So, let’s imagine that you invest $10,000 in a 10-year bond with a coupon rate of $300. This means that you will be paid $300 each until the bond matures, and when the bond matures, you will get your original $10,000 investment back.
But now, let’s say interest rates go up. One year into your bond investment, interest rates are now at 5%.
This means that the market value (the attractiveness to buyers) of your bond goes down because nobody will want to buy your bond with its 3% coupon rate when they could buy one with a 5% coupon rate. This means that you are likely stuck with your bond until it matures. (Or you could sell it at a discounted rate - but we’ll save the discussion on calculating the future value of bonds for another chapter).
Understanding Return
The other side of risk is return. Return is the profit you earn from your investments. It is usually expressed as a percentage of the initial investment. Returns can come from various sources, including:
1. Capital Gains: The profit made from selling an asset for more than you paid for it.For example, imagine you decide to invest in shares of a company called the Great Investment Corporation. You buy 100 shares of the Great Investment Corporation at $50 per share. After holding the stock for a period of time, the price of the Great Investment Corporation's shares increases to $75 per share, and you decide to sell your shares.
Initially, you purchased 100 shares at $50 each, making your total initial investment $5,000. When you decide to sell, you sell the same 100 shares at $75 per share, receiving a total of $7,500 from the sale. To calculate your capital gains, you subtract your initial investment of $5,000 from the amount received from the sale, which is $7,500. This results in a capital gain of $2,500.
2. Dividends: Payments made by a company to its shareholders, usually derived from profits.Let’s take the same example and imagine that you are still holding 100 shares of the Great Investment Corporation. The Great Investment Corporation consistently generates profits and has a history of paying dividends to its shareholders. At the end of the quarter (three months), the company announces that it is paying its shareholders $1 per share. As you hold 100 shares of the company, you will receive $100 in dividends for that quarter.
If the company does that for four consecutive quarters (one year), your investment could return $400 in addition to the increase in capital gains (if the share price is going up).
You could reinvest these dividends by buying more shares of the company, thereby increasing your potential capital gains and future dividends. Or you could invest these dividends in another investment.
Reinvesting dividends is one of the things you do when you rebalance your portfolio quarterly, bi-annually, or annually.
3. Interest: Payments made to investors who hold bonds or other interest-bearing securities.Dividends are one way that stock investments yield a return, and interest payments are another way that bond investments yield a return.
Think back to our bond example above. Imagine that you have invested $10,000 in a 10-year bond with a coupon rate of $300.You will be paid $300 each until the bond matures. This $300 is an interest payment. Reinvesting these interest payments is one of the things you do when you rebalance your portfolio quarterly, bi-annually, or annually.
Risk-Return Tradeoff
The risk-return tradeoff is a fundamental principle in investing. It states that the potential return rises with an increase in risk. For every investment, you want to understand the risk of the investment and the return that the investment will yield. When building and re-balancing your portfolio, you will find a balance between the level of risk they are willing to take and the returns you hope to achieve. This balance is often determined by your risk tolerance, investment goals, and time horizon, and all three of those things will change over time.
Empower Your Wealth: Become Your Own Financial Investment Manager is a 20 part series that teaches readers how to self-manage their investments. It covers basics to advanced strategies, emphasizing the importance of financial independence, diversification, risk management, and technology.