When working with clients on investment strategy, I will issue them with an Investment Policy Statement. This document will set out Bluewater’s investment philosophy, the clients own investment circumstances, our recommendation and fees. They then have to sign a Summary of Understanding and Declaration. The first point in this summary is that they understand that there are different types of risk when investing. But what do those different types of risk mean?
Systematic risk is the risk that applies to the entire market and not just confined to a particular industry or company. For example, fears that the US Fed are going to stop their bond buying programme has spooked the whole market and not just the companies who are selling bonds to the Fed. It is impossible to completely avoid it by diversifying across a number of sectors. It can be managed by investing in other asset classes such as fixed income, cash or commodities.
Unsystematic risk is the risk that is specific to a company or industry. For example, electric vehicles is a risk to energy companies or regulatory changes to an industry. It is impossible to avoid unsystematic risk completely as some of them can’t be predicted e.g. strikes or natural disasters but it is very easy to reduce unsystematic risk by diversifying into other industries.
Liquidity risk is the risk that a company can pay its short term debts without running out of money. It can also apply to a funds ability to meet redemption orders. We recently saw this with property funds when they were running low on cash reserves and didn’t want to have to sell buildings in a fire sale to meet redemption orders. You can avoid liquidity risk by investing in assets with low liquidity risk. Bonds and shares are extremely liquid and you will be able to find a buy very easily, even if you are not wholly happy with the price. Assets such as property or private equity can be difficult to find a buyer for and you may have difficulty in selling quickly.
Capital risk is the risk that you can lose all or part of the money that you invest. Unless your investment has a capital guarantee, investing your money exposes you to an element of capital risk. The most effective way of managing capital risk is to diversify your investment in an open ended investment with quality assets. By having an open ended investment, your investment will not mature at a time when markets are down. You can wait until markets return before redeeming your position. Investing in a diversified basket of quality stocks spreads the risk across companies that have strong balance sheets and are unlikely to fail.
Income risk applies to money market and other short-term income fund strategies. It is the risk that the yield of the fund will decrease because of a decline in interest rates. Fluctuation of interest rates can have a significant effect on the performance of money market funds because the income generated by the fund is continually reinvested at the current rate. You can reduce income risk exposure by diversifying into longer term investments with fixed rates of interest.
Inflation risk is the risk that the future value of an asset will be reduced by inflation. The most obvious example of this is cash on deposit. With zero interest rates, the future spending power of deposits will be less than it is today. Bonds are also vulnerable to inflation risk. Most bonds receive a fixed coupon for the term of the bond. High inflation will impact on the real value of that coupon payment. This is one of the reasons that long term bonds are deemed riskier than short term bonds, inflation will reduce the real value of the coupon and investment amount when the bond matures and you get your capital back. You can mitigate inflation risk by investing in inflation linked bonds which adjust the coupon and principal payments according to to the consumer price index.
This is the risk that you get from investing in assets in a different asset. As European investors, we are most commonly exposed to the risk of the exchange rate between the Euro and the US dollar. As the exchange rate between the two countries fluctuates, the value of the assets that you own will fluctuate as well. You can reduce this risk by hedging, that is locking in an exchange rate. We use this strategy for bond funds as currency risk can be higher than bond volatility but do not hedge equity investments.
Default risk is the risk that a borrower does not repay its debts. Presently, Chinese property company Evergrande is on the verge of defaulting on its repayments to bondholders. And in the United States, if Congress does not increase its debt ceiling, the US will default on its debt obligations with catastrophic consequences around the world. Credit agencies rate corporations and nations to gauge investment risk. AAA, AA, A and BBB is considered investment grade. Anything rated BB or lower is considered non investment grade or junk. The lower the grade, the higher the interest rate you can demand from the borrower to compensate you for the higher risk you are taking. The best way to mitigate against default risk is to investment in investment grade bonds and accept a lower coupon for your investment.
These are just some of the main types of risk you may be exposed to when you investment but the list is not exhaustive.
If you have any questions, drop me an email at firstname.lastname@example.org
04 October 2021