There are several types of risks an investor faces and hopes to mitigate when he or she invests in the stock and bond markets. I believe they are as follows.
Buying individual stocks is an option available to investors. This approach contains risk that is known as individual stock risk and encompasses the many things can happen and have happened to what are considered quality individual companies, which has caused their stock value to drop overnight. Events like, but not limited to, the resignation of a CEO, a scandal associated with that company, a regulatory issue, missed earnings estimates, lowering of expectations, or downgrading of the stock by an analyst represent just a few factors contributing to this.
Purchasing a mutual fund or exchange-traded fund (ETF) in that sector is one option that may mitigate this risk. Diversification potentially lowers individual stock risk while creating exposure to a “basket” of stocks in that particular industry.
Stock Market Risk
Stocks are known as equities; stock type funds are known as equity funds. Individual stock risk is mitigated by the diversification of the fund, but stock market risk is retained when one invests in an equity fund (like Large Cap Growth, Mid Cap Value, or even sectors like healthcare or technology as examples). Generally, if there are broad losses in the stock market (equities), equity indices and sectors tend to lose value as well. This may not always hold true because it is possible for some equity indices or sectors to actually rise when most stocks are declining. Funds that move opposite from another fund or from the market are said to be non-correlated.
The traditional way of mitigating this risk is to use assets that tend to be non-correlated. The most common be non-correlated assets are bonds or bond funds. Usually, the investor will select some combination of bonds or bond funds to sit alongside his or her equity investments. Combining equities and bonds or bond funds are referred to as asset allocation and is considered both an “art” and a “science”. Other assets like commodities or precious metals also tend to be non-correlated and can also be used to lower equity risk in portfolio optimization.
An investor is essentially lending money to an entity – whether to a government or a corporation – when he or she buys an individual bond. The entity agrees to pay the investor a specified rate of return and agrees to return the original investment at “maturity” (the length of the term). Another word for bonds is “debt” – the investor is the lender and the entity is the borrower.
Generally, there are three kinds of bond risk. The first, credit risk, is the potential uncertainty of the entity to meet its obligations – to pay the investor the agreed upon interest and eventually return the invested principal to the investor. When an entity fails to pay the agreed upon rate of interest and return the original invested principal to the investor, the bond is considered to be in default. There have been many notable government entities and corporations that have defaulted on their bonds, thus failing to meet their agreed upon contractual obligations. Two higher-profile examples that come to mind are General Motors and Orange County, California.
The second kind of bond risk is related to interest rates. Bond prices are inversely correlated to interest rates; as interest rates rise, bond prices fall, and vice versa. The risk that an investor faces is that interest rates will rise after they buy bonds. The investor and the borrowing entity are both locked into the agreed upon interest rate and term of the bond, which are typically not renegotiated if interest rates rise.
The third kind of bond risk is liquidity risk. Short-term bonds (2 years, for example) are considered to have the most favorable liquidity, but also pay the lowest interest rate to the investor – and vice versa with longer term bonds.
Ways to mitigate bond credit risk (related to the issuing entity) is to buy high quality bonds (for example, AAA rated). By diversifying types of bonds purchased and staggering purchase dates and the maturity dates, liquidity and interest rate risk may also be mitigated. This process is called “bond laddering”.
Bond Fund Risk
Any or all of the above risks can be present when buying individual bonds. An alternative to investing in individual bonds would be through the purchase of bond funds or exchange traded funds. These types of funds are collections of bonds that have been purchased by fund managers. The underlying bonds in a bond fund typically offer diversification in quality, duration and the bond issuer. This sounds reasonable, but the question remains, where is the risk?
The fund does pay a dividend which comes from the underlying bonds which the fund owns. However, the price of the bond fund also typically fluctuates because an investor cannot lock in a specific bond price. Factors such as changes in interest rates can drive the value of the bond fund up or down. Bond prices are inversely correlated to interest rates; as rates rise, the value of the bond fund tends to decline. The biggest risk in owning bond funds is that interest rates will rise and the value of the bond fund will potentially decline.
Risk in Active Management
An alternative approach to asset allocation is active investment management. While there are no guarantees, active management seeks to produce better returns than those of passively managed index funds. Those who utilize active management apply methodologies that actively change assets or asset classes to reflect changes in risk and market conditions. Through these methodologies, managers seek higher rates of return and/or lower risk.
The risk in active management is that historical patterns may not necessarily be repeated in the future.
The best way to mitigate this risk, in our judgment, is to perform a “stress test”, which tests the methodology through the periods of time for which it was not optimized. This can get technical, but there are ways to validate active management models. Real-time results are also a way to view performance and risk.
Famous investor and money manager, Seth Klarman, said, “Most investors are primarily oriented toward return, how much they can make, and pay little attention to risk, how much they can lose.” Both rate of return and risk need to be evaluated together. There is long-term value in placing high importance on mitigating risk.
Each approach to investing can use risk management to match the risk tolerance of the investor and to provide a satisfactory investing experience – and help meet his or her investing goals.
Ben Reppond is CEO and Investment Manager of Reppond Investments. Reppond Investments, Inc. is a registered investment adviser in the States of Montana and Washington. We may not transact business in any state where we are not appropriately registered, excluded or exempted from registration. Individual responses to persons that involve either the effecting of transactions in securities or the rendering of personalized investment advice for compensation will not be made without registration or exemption.
Investment Advisory Services offered through Reppond Investments, Inc.
Please click on the embedded links for specific details related to sources and comments cited in this article.