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The word "risk" has different meaning
to different people. However we are concerned
with three distinct risks in investments: default
risk, inflation risk and volatility risk.
Default risk
is fairly straightforward. This is the risk
that the investment may lose all value and file
for bankruptcy. The result is a total loss of
investment. For example, if an investor were
to place all of their assets in one company
(or industry), this would be considered default
risk. Sometimes, the risk pays huge rewards,
such as it did for Bill Gates of Microsoft.
However, recent investors in PeaPod.com, e-toys
and Stamps.com have had a very different experience.
This risk is easily overcome by diversification
into a number of issues representing varied
industries and economic sectors. Issue diversification
is one of the main benefits of using mutual
funds, as the level of default risk is significantly
lowered.
Inflation risk
is rarely talked about, but can have a significant
impact on the value of our assets over time.
With inflation, the dollar you earn today will
buy less goods and services at a later date.
For example, in twenty years after a 3% inflation
rate, it will take $1.81 to buy what a $1.00
will buy today. To reduce this risk, the investor's
long term program needs to be invested aggressively
enough to overcome this effect.
The risk which is most talked
about in connection with investments is volatility
risk. Volatility can be defined as
the period-to-period fluctuation of prices.
This fluctuation can sometimes cause anxiety
among investors, which, in turn, can influence
them to depart from their long-term investment
goals and planning. In addition, if the investor
is in need of money during the low point in
the price fluctuation, there is a risk that
the investment will be unable to recover.
Volatility Risk is usually
measured as Standard Deviation of monthly returns
over a long period of history. Standard Deviation
(SD) is a statistical measure that defines the
probability of an event occurring. For example,
Large Cap Stocks have a SD of 16.3% with an
average 12-month return of 14.5% (using data
since 1970). This data is interpreted that 67%
of the time investors can expect a 12-month
return between -1.8 and 30.8%, a wide range.
Increasing the probability to 95%, the range
widens even further from a low of
-18.1% to a high of 47.1%. Over this thirty-year
time frame, the largest return was a 77.8% for
the twelve-months ending June of 1971, while
the lowest return was -40.4% for the twelve-month
period ending September of 1974.
If we look at this graphically
using different asset classes, we can see that
the volatility risk is different over different
types of asset classes. In the graph below,
we see that the smallest circle represents Money
Market investments and the size of the circle
represents the degree of volatility which can
be expected with 67% certainty.
Volatility Risk can be lessened
through allocation of investments over what
we call asset classes. In fact, through asset
allocation, we are able to utilize the differences
of the asset classes to effectively lessen the
risk of some asset classes while maintaining
the returns. For more information, please refer
to Asset Allocation.
The articles
and opinions in this publication are for general
information only and are not intended to provide
specific advice or recommendations for any individual.
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