A Brief Introduction to Risk

On 05/03/2010, in Investment Concepts, by Jordan Wilson
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The concepts of risk and return are core to understanding the investment process.

Investors wish to maximize their returns while minimizing risk. Asset classes are compared on the basis of their risk and their risk-return expectations. Hedging activities are conducted to reduce risk while leveraging helps to increase risk.

Everything investors do relates to risk and return.

But what is risk?

In general, risk is the probability of harm, loss, or injury occurring in the future. The damage may be emotional, physical, or financial.

For each individual, risk is a different concept. One based on their personality and the unique experiences they endure in life. Because of this, one’s perception of risk changes over time.

When young and carefree, there is no thought of death. But suddenly you get married, buy a home with a large mortgage, and have a child; your views probably change. What will happen to my family if I am suddenly gone? Life insurance becomes a very interesting topic.

Risk may be categorized in many ways.

As you may hear or read about different terms for risk, let us quickly review the major classifications. That way, if someone mentions risk to you in a different context than the ones we discuss in detail, you will have some idea what they are referring to.

Fundamental Versus Particular Risks

You may see risks compared as fundamental or particular.

Fundamental risks are impersonal in nature and affect a large number of people simultaneously. War, hurricanes, and inflation are examples of fundamental risks.

Particular risks are the result of individual events and the results are much narrower. House fires, car theft, and murder are examples of particular risks.

Dynamic Versus Static Risks

Risks may also be contrasted as dynamic or static.

Dynamic risks arise from changes in the environment or economy that impact specific groups. When a dynamic risk occurs, for the individual directly impacted, there will be a loss incurred. However, for others not directly affected, or those nimble enough to quickly change their current situation, there may be opportunities for gain.

For example, as more people obtain their news electronically there has been a significant reduction in newspaper readership. This has caused many bankruptcies. However, some internet news organizations have grown and prospered at the expense of old media.

Or consider that government regulations on fuel and carbon emissions have resulted in a significant restructuring of the auto industry. While this negatively affects those producing Hummers, makers of hybrid vehicles are benefiting.

Static risks, in contrast, are present even if there are no changes in the business environment. The risk is a constant regardless of the situation. Even when everything is going well there will be always be a percentage of people that suffer a loss.

For example, even when the stock market is experiencing a lengthy bull market (i.e. broadly rising), some investors will still lose their capital. Or during periods of strong economic growth, there will continue to be individuals laid off from work. There is a risk of loss in good times, not simply the bad.

Pure Versus Speculative Risks

Finally, risk may be classified as either pure or speculative.

A pure risk may be either fundamental or particular. It may also be dynamic or static. However, a pure risk can only have two possible outcomes; a loss or no change in status. The potential loss from an earthquake, house fire, or losing one’s job are pure risks.

Unless you defraud your insurance company, you cannot prosper from a pure risk.

Speculative risks are different from pure risks in one important area. A third possible outcome exists. Like pure risks, speculative risks may have the potential for loss or no change in status. But there is also the possibility of incurring a gain.

Buying a common share of a public company is a speculative risk. When selling, you may lose some or all of your investment. You may also sell for the same price as you paid, thereby experiencing no change in status. Or you may make a profit on the sale.

Some people believe that, at times, dynamic risks can also be considered speculative risks. That is because they see individuals prospering from the impact of a specific dynamic risk. I understand the point but prefer to view them separately.

With a dynamic risk the potential gain is due to subsequent actions. The government introduces minimum fuel standards. Automakers that do not comply suffer a loss. Those that are agile enough to start a new business or adjust their current capabilities may prosper. But it is the subsequent actions that leads them to the opportunity, not the risk itself.

With a speculative risk, it is only the initial decision that results in a gain, loss, or no change. A speculative risk might be the business decision to develop and market an electric vehicle in anticipation of new laws affecting gas consumption. If the business decision is correct and new laws are enacted, the company may do well financially. If there are no laws imposed, consumers might stay with gas powered autos and the business may fail.

That business decision is the speculative risk.

Investing is always a speculative risk.

We will focus on speculative risk because of its relationship to personal investing. And, if you do not mind, I will change the label from speculative risk to investment risk. This will save some potential confusion down the road when we look at speculation as a distinct component of the investment process itself.

Before we get into investment risk, we shall consider its counterpart, pure risk.

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