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Assessing Portfolio Risk
Most
investors know that they should evaluate their risk tolerance when
considering an investment. Oftentimes, investors think of risk only in terms of
possibly losing money. However, in the investment world, risk is broadly
defined as the probability that the actual return from an investment will be different from its expected return. Actual returns (making or losing money) can be
affected by a number of factors, and total risk is a measure of variation in
return due to all sources.
General Risk
General risk refers to factors that lie outside individual companies, but that
affect an entire class of investments, or the market as a whole (although
individual companies may be affected to varying degrees). One type of general
risk, known as market risk, may be a function of political,
economic, and sociological events, or changes in investor preferences. For
example, market risk occurs when the overall business climate changes, bringing
expectations of lower corporate profits in general, and causing the larger body
of common stock prices to fall.
A second
general factor that may broadly affect all companies is interest rate risk?the fluctuations in the general level of interest
rates. The bond market is particularly sensitive to interest rate risk in that
bond prices tend to move in the opposite direction of interest rates. Although
fixed-income securities (such as bonds) are generally the securities most
affected by interest rate risk, other investment vehicles may be affected as
well. Companies that borrow heavily for plants and equipment (e.g., utilities)
may see their common stock prices affected by changes in the cost of borrowing.
A third
general risk factor is purchasing power
risk?the impact of inflation (a general rise in prices) or deflation (a general fall in price levels) on an investment. Purchasing power risk is
a reflection of the uncertainty of
price levels during the time an investment is held, particularly the inability
of a particular investment to keep pace with inflation. For example, if an
investment returns 3% annually, but inflation averages 4% annually during the
holding period, the investor will be losing purchasing power by holding the
investment. Purchasing power risk is generally highest in investments paying
relatively low fixed-interest rates, such as savings accounts.
Specific Risk
In contrast
to general risk, specific risk is that portion of total risk that is unique to a firm, industry, or property
(in the case of a real estate investment). Specific risk is typically
subdivided into business risk and financial risk.
Business risk is the risk associated with the
nature of the enterprise itself (or the industry in which the enterprise
resides) and measures the company?s ability to meet its obligations, remain a
profitable entity, and provide acceptable returns to investors. It is generally
believed that like kinds of firms or properties have similar business risk.
However, among similar businesses, differences in management, operating costs,
and market opportunities can create different levels of business risk.
Financial risk measures a company?s mix of debt
and equity used to finance its operations. Debt creates legal obligations
(i.e., principal and interest payments) that must be met before earnings are
distributed to owners (e.g., dividends to stockholders). The larger the
proportion of debt, the greater the financial risk.
Risk can be
affected by political, social, and economic influences. Consequently, fitting
individual risk tolerance to specific investments is an ongoing process that
examines the interplay between the individual investor?s objectives and the
constantly changing sources of risk that can impact investment returns.
Source:
Liberty
Publishing
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