Risks faced in holding financial assets

What is risk in financial terms? It is the degree of uncertainty that the realized return on an investment will not equal the expected return. It may also be expressed as the degree of volatility or variability in returns.

Past volatility is easy to measure. Future volatility is not and this is where the probability of return enters the picture.

Above we identified two sources of investment return: income and price change. To this we now add a third: reinvestment of income, which plays a substantial role in the final investment outcome. Thus we have three sources of investment return in the case of the financial markets:

• Income (dividends in the case of equity).

• Change in price (capital gain or loss).

• Reinvestment of income.

Investment risk thus arises from the variability of return in these sources. For example:

• Companies may perform badly from year to year and some may even go out of business. These events will affect the prices of the relevant shares.

• Earnings may change from year to year.

• Dividends may change from year to year.

• Interest rates may be volatile at times, which affects reinvestment income.

In investment literature risk is classified into two "types": systematic risk and unsystematic risk. Systematic risk is defined as risks that are inherent in the financial and/or economic system (hence the name). Little can be done about this risk-type. Examples of this type of risk are:

• Tax changes.

• Upward changes in the central bank accommodation rate.

• Sudden change in the economic growth rate.

• Declaration of a war.

• A major change in the exchange rate.

Unsystematic risk is security-specific risk. This risk-type arises from the activities of the issuers of shares, i.e. the companies, and the industry of which they are a part, and may be seen as the major factors that affect the income flows of companies. Analysts generally categorize this risk-type into business risk and financial risk.

Business risk is the uncertainty of income produced by the company itself and/or the industry the company is a part of. Examples of business risk:

• Prolonged labour strike.

• Arrival of serious competition from offshore.

• Harmful management decisions.

• Negative change in product / service quality.

All these factors have an effect on sales variability, and this is one of the main determinants of income / earnings variability.

Financial risk is introduced when debt is utilised as a source of capital, and is used injudiciously by the company. Examples are borrowing at a time when rates are high and are about to fall, borrowing in excess of funding requirements and misuse of the funds so that the funds do not contribute to the income of the company.

Some analysts include liquidity risk as a third type of unsystematic risk. This is the risk of the segment of the share market in which the relevant share is being illiquid so that fair market value cannot be obtained.

Risk may be portrayed as in the Figure 4. Market (systematic) risk is out of the sphere of influence of the investor and the companies and this type of risk cannot be "diversified away". However, unsystematic risk can be "diversified away", by which is meant that risk is reduced by increasing the number of shares in the portfolio. Although this subject is the domain of portfolio theory, it is touched upon in the following section.


Figure 4: risk

Risk predisposition

Investors have one of three basic predispositions or preferences for risk: risk-seeking, risk-indifferent and risk-averse (see Figure 5). The risk-indifferent investor is not a wise one because s/he is willing to accept more risk without expecting / requiring a higher rate of return.

The risk-seeking investor has a brain problem because s/he is willing to accept more risk for a decline in return (in fact the risk-seeker will not be an "investor" for long, but a deficit economic unit). The risk-averse investor is the normal investor, i.e. s/he has a healthy attitude toward risk, and will only accept more risk if there is a chance of a higher return. This means that s/he requires or expects a higher return for a greater level of risk.

risk profile

Figure 5: risk profile

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