Tuesday, June 1, 2010

All kinds of Risk

Many authors have defined numerous risk categories such as:
• Market risk (volatility)
• Interest rate risk (changing interest rates)
• Equity Price Risk (pricing volatility of shares in individual companies)
• Foreign Currency Risk (exchange rate variations)
• Commodity Price Risk (changing commodity prices)

Reality is that many of these risks are temporary and disappear with a long term investment horizon – minimum 5 years. The earlier posted graph by Bernstein (Fig. 1) comes to mind as well as our discussion regarding price volatility which disappears over the long term as shown in figure 2.

Figure 1 shows Berstein's Probability of loss table.

Figure 2 shows that investments made during down markets over time rarely fall back below the initial purchase price.

Changes in interest rates can be nastier because interest rates appear to be roughly cyclical with many years of rising interest rate trends alternating with falling interest rate trends. These periods may last for decades and thus interest rate related losses are difficult to recoup. However, these risks lie in the eye of the beholder and depend greatly on the investment horizon. Ironically, interest risk increases with the length of the investment horizon. If you locked in a GIC rate for a year, your risk is very low while locking it in for 30 years in a rising interest rate environment may be an outright disaster, especially when inflation rises simultaneously (as often is the case). With GICs you’ll lose in purchasing power and you lose in opportunity costs when compared with higher rate paying GICs. When dealing with bonds, you may sell prior to maturity of the bond, but the bond’s value change will then be realized immediately.

So if as long term investors price volatility is not an issue and when dealing with fixed income a shorter (maximum 5 years) risk is muted (provided you hold until maturity), then what are the major concerns or risks an investor should focus on? For me the answer is found in the two profit centers of each investment: Cash flow and Appreciation. Cash flow, although variable, is more predictable on the short term than appreciation and it is part of your insurance policy against nasty consequences of a more volatile appreciation. The other component of your insurance policy is cash. So each investment portfolio should be seen in terms of 3 components: Cash flow, Appreciation and Cash. We will address each separately in upcoming postings.

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