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As exposure & ease of access to investment opportunities has increased exponentially, the number of people participating in the markets has also increased substantially; Both seasoned finance professionals & new investors, however, must remain cognizant of the main risk vectors that can expose them to downside risks.
This report explains the main risk sources that investors with a short-term, medium-term, & even long-term investment horizon should understand for mitigating downside risks.
The type of risks, their key attributes, and mitigation strategies are expounded/explained in this report. Parties interested in the money market funds, short to medium-term allocations in stocks & bonds, and even alternative investments can utilize this work to understand the primary risk vectors & the mitigation approaches that can be applied to reduce or eliminate them.
For an in-depth understanding of economic, political, & currency risk, from the perspective of a business, see our thorough report.
Issuer related risk (credit & equity risk)
This type of risk affects the equity & debt (bonds, etc.) issued by a specific entity (company). The issuer can default on its debt, or the equity issued by the issuer, due to a failure to remain a going concern, may fall precipitously in value.
This can happen, for example, when the demand for the main product category of the firm declines due to new contenders rising or due to a competitor technologically leapfrogging the subject firm; alternatively, idiosyncratic factors such as a court case, management, product, or employee-related scandal(s), etc., can also lead to similar outcomes. The examples of Kodak, WorldCom, & Napster are relevant here.
A further illustration that can be used here is that of Apple (AAPL). As its highest revenue source is the iPhone, a significant decline in the demand for iPhones, or an emergence of new tech, that leapfrogs the iPhone technologically, should significantly impact the value of the outstanding debt of the company, as the interest rate investors demand for holding the company's debt should rise.
The value of the equity, for the same reason, should also decline severely, as future growth prospects decline (for a further in-depth understanding of this point & an example of factors that should be examined, see report on the creative destruction process, AAPL growth prospects, discussion of AAPL's next CEO, AAPL market share expectations, & iPhone's future prospects) (for understanding how to evaluate business staying power, see our report). Beyond the medium-term horizon (2-5 years), these concerns gain further importance.
While, on the face of it, this concern seems very obvious, it is often ignored, especially by novice investors. It should also be noted that while it may seem like the present industrial behemoths that dominate the landscape in their respective industries may last for a very long time, analysis and research suggest that the lifespan of an average company is now 18 years; thus, assuming that a firm may last long term, without an in-depth analysis, may be inaccurate.
As the pace of technological advancement and the emergence of novel business models and approaches rise, the lifespan of companies is likely to shrink further (IMD, 2016). Therefore, this is a very important concern that should be thoroughly studied by examining the main product categories of the subject company, and examining their future prospects.
The issuer may also be dependent on exports to a specific international region that may be negatively impacted by a recession or adverse economic conditions. On the other hand, economic conditions, of course, can also impact the issuer, i.e., a reduction in national/regional spending, income, & expectations regarding future economic conditions may impact the issuer. Supply related issues, the emergence of substitutes, change in consumer perceptions, or an overall industry-wide decline in demand can also negatively impact the firm.
As these factors can reduce the revenue of the firm, broadly, they can impact both the equity of the issuer and the debt as well: As due to a reduction in the amount available to service & repay the debt is reduced, the chances of default increase; as future prospects of the firm weaken, the value of equity (share price) should also fall precipitously. See also: Why do all financial assets correlatively fall in a market crash
To reduce the exposure to this risk, investors should reduce exposure to single companies or sectors, i.e., minimizing the exposure to specific companies and sectors. A quick rule of thumb investors can use is to keep exposure, per business sector, lower than 25% and lower than 5% per company overall.
For example, more than 25% of the investments/allocations shouldn't be in the real estate, tech sector, etc., and a wide variety of sectors with a positive outlook should be included.
Similarly, representation of a single company shouldn't be more than 5% of the portfolio, i.e., if an investor has $1,000 to invest and she is interested in Microsoft (MSFT), she shouldn't allocate more than $50 in Microsoft (MSFT) or more than $250 in the tech sector, to reduce the exposure to volatility in a specific name or sector. A similar approach is applicable for those interested in cryptocurrencies (for an analysis of the endgame of crypto, see our report; for comparison and prospects of Shiba Inu vs. Bitcoin, see our report).
Another approach that can be used is to keep investment horizons short with a re-examination carried out every 3 weeks. For example, if an individual is interested in, say, Nvidia's stock and has a specific theory as to why it would rise in value, she should re-examine the position every 3 weeks, and if she is trying to keep her portfolio safe from volatility, she should consider shorter horizons.
In this way, through constant re-examination, it is more likely that the investor would avoid being 'locked in' an adverse investment and is more likely to carry viable names long-term. This is especially true when buying bonds rated below investment grade. Those interested in such bonds can particularly benefit from keeping investment horizons short.
Another viewpoint prevalent in money management circles is that those looking to avoid volatility should have a higher allocation in government securities; while this may be a viable short-term approach, this approach may not be viable for long-term investment horizons as per the current economic conditions (see report for a further explanation of this point).
Market & interest rate risks
This risk, again, impacts both equities and fixed income securities. Primarily, due to a change in the supply and demand of credit in the overall economy, interest rates can change (the supply and demand are influenced by long-term economic growth prospects and inflation, fundamentally).
Interest rates can also be maneuvered/influenced 'artificially' as per the strategy of the central bank of the country, as it is done in a 'dovish' manner (when the economy is stagnant or in a recessionary environment) to stimulate the economy & in a hawkish manner for achieving a contractionary objective (usually done when the economy is overheating and there are serious concerns regarding a rise in inflation).
Other than natural changes in the supply and demand of credit, central banks, such as the Federal Reserve in the U.S., can maneuver interest rates through the 'monetary transmission mechanism,' which is a method to influence monetary policy through the bank's policy rates.
The FED, for example, can maneuver the federal funds rate (rate banks charge each other for lending), influence the reserves that member banks hold and the reserve requirements, conduct open market operations, i.e., buying and selling securities to manage the money supply in the economy.
In a fractional reserve banking system, as the reserves of the banks increase, they try to lend more funds to gain interest, & when reserves fall, the lending is reduced. As more money is made available for lending, the interest rate banks charge is reduced due to an increased supply of money. Thus, we can see that interest rates, although dependent on long-term supply & demand of capital, can be influenced by the central banks in the subject jurisdictions as well.
But how can changes in interest rates create investment risk?
Prices of equities and bonds are heavily influenced by the overall interest rates in the economy; for example, the value of equity is often calculated through models such as the Capital asset pricing model (CAPM), and bonds are discounted based on the excess credit risk and the liquidity risk they expose investors to, compared to government bonds, which are considered risk-free (see report presenting a contrarian point of view on this issue: a discussion on the risk-free nature of government bonds).
As the discount rate applied to the future cash flows of equities/bonds/other assets rise, their price/value decreases; however, if interest rates fall, the price/value of the aforementioned assets should rise. This is how fluctuation in interest rates can create risks for the investors.
On the other hand, for some illiquid securities/assets, there may not be an actively traded market where investors can readily exchange such assets for cash; this condition refers to market risk. For example, a person may hold a 4-carat pink diamond, or rare coin, wristwatch, etc., the value of which may be estimated to be in a range; however, if the seller is unable to find a buyer, the seller, in that condition, would suffer a market risk, i.e., there might be a small market where a buyer cannot always be found or no market at all.
It is important to note that even assets with smaller markets (for example, wristwatches, rare coins, artwork, etc.) may be influenced by the overall interest rates in the economy and the money supply. An estimation of the covariance of their price with interest rates can be done through methods such as linear regression.
To reduce exposure to these risks, technically, (1) tools such as derivative instruments can be used: for example, if a stockholder is concerned about the price of her holdings falling due to a rise in interest rates or economic downturn, etc., she can buy a put option for a specific period, to eliminates that risk, for the period of concern.
Alternatively, a stockholder also has the option to increase exposure to an imminent reduction in interest rates by buying calls option on the name they already hold. Nonetheless, it is important to note that the downside or upside risk that the investor is trying to mitigate should be higher than the cost of acquiring the options; otherwise, such a strategy wouldn't make economic sense (options premiums rise when volatility is expected to increase).
(2) Investors can also diversify by acquiring international names, which are based in countries with a business & credit cycle that does not correlate highly with their home investments. Doing so will ensure that even if the value of assets in the home country is impacted by a change in local rates or economic conditions, the internationally diversified side of the portfolio is not.
For investments that are very sensitive to rates, keeping the investment horizon short can reduce some impact of rates.
For assets with a small or no market, the investor, at the time of acquisition, should conduct (1) an analysis of the time that may be needed to sell that asset in the future, (2) the probability of finding a buyer, and (3) estimate a recoverable value, to estimate whether the investment is worth making. For example, let's assume a buyer is evaluating buying a rare diamond for investment:
She should first examine the time it takes on average for selling such stones, the cost of tying up the funds for the period, the expected future sale price, and the price if sold in an emergency, i.e., pawned, etc. Let's assume that it, on average, takes about 2 years to find a buyer, the probability of finding the buyer is 25% in 2 years, 45% in 5 years, & 30% of not finding a buyer and selling to a pawnbroker in 6 years; the interest return she can gain by investing in jewelry stocks is 10% p.a.
Let's assume that the selling price to a buyer is expected to be $1,000,000; however, if sold in an emergency, it would be $450,000 (pawn trader). How much should she be willing to pay for the diamond? A probability attached value as seen below can be derived first:
As we can see, the expected, probability adjusted value that is likely to be gained from acquiring this diamond is $373,360; the buyer, thus, should only acquire it if she can buy it for under this cost (cost of finding a seller and finding the diamond have been ignored in this simple example), as acquiring it over this cost wouldn't be feasible and more like to gambling, and hence, exposing the buyer to risks.
Foreign Exchange risk
This risk simply means that assets/positions held in a foreign currency, say, for diversification, etc., may experience adverse market moves; alternatively, if an investor holds a large position in cash, an adverse move against the home currency can result in a deteriorated buying power when it comes to international assets/imported items.
An increase in long-term inflation, especially for economies highly dependent on imports, as imported goods in the economy would become more expensive to acquire in the domestic currency, may also arise. This is a very self-explanatory concern, therefore.
This risk can be neutralized in various ways; for example, if a party holds foreign currency bonds or shares, and they are concerned that the currency in which the assets are issued may fall, hence, devaluing their investment as well, when converted in their home currency (this would, of course, impact the yield on investment as well), they can neutralize this concern by selling a futures contract in that currency, for the duration of the holding period of the asset.
I.e., if a party holds a bond in Japanese Yen, say, for six months starting in January, they can buy a June future contract (in a quantity that closely matches the exposure) of USDYEN to hedge their bond exposure; this can be done through any FX broker. If the Yen falls against the USD at the date of maturity, the party will lose money when the principal is converted back to USD, but the loss would be offset by the gain on the futures contract, eliminating the currency volatility concern.
A similar approach can also be applied for other forms of assets that are to be acquired from or sold to a foreign buyer.
Alternatively, parties with very low currency risk tolerance can hold most assets in their domestic currency so that they can eliminate this concern. Those pessimistic about their home currency and its deterioration against other top currencies, on the other hand, can hold most assets in a stable foreign currency, such as the Swiss Franc, gold, etc.
It should be understood that the factors explained here are not all-encompassing; factors expounded here are the main/fundamental factors that investors should be highly vigilant about.
Beyond these factors, investors should thoroughly investigate idiosyncratic risks specific to the firm/asset class they are investing in; specific microeconomic factors, i.e., factors relevant to the business model and operations of the firms that they intend to make an allocation in, as well as the industry at large, are also of paramount importance.
As the investment horizon shift from short & medium term to long-term, the focus should also include the broader economic analysis of the regions of exposure and the political, technological, legal, and environmental factors for a more accurate assessment.
(Bibliography) Adapted from: CFA Institute (2019). CORPORATE FINANCE AND EQUITY. ISBN 978-1-946442-79-6.
CFA Institute (2019). Economics. ISBN 978-1-946442-77-2