Dave Sather’s Money Matters

February 29, 2012 

Identifying Risk

With the semester back in full swing at Texas Lutheran, Bulldog Investment Company had their first presentations of 2012. During the competition the comment was made that a particular investment should be considered because it was “less risky”. 

Although I disagreed with the comment, it led to a very constructive conversation—one we have had with many clients throughout the years. 

Often, we refer to “risk” as a one size fits all term. However, that is a gross oversimplification. Depending upon how you think about the matter, there are at least ten commonly identified types of risk. As such, the word “risk” should always be preceded with an adjective describing the type of risk we are addressing. 

For instance, default, or business, risk comes when one investment stumbles (think Enron or General Motors). Usually, diversification with 20 to 30 companies alleviates the vast majority of this type of risk. Market risk comes merely from being exposed to a broad class of assets—such as the stock market. Recall how correlated the world’s financial markets were in 2009. Even if you held very high quality stocks in 2009, they still fell significantly.   

These two types of risk are the ones most of us are referring to when we talk about “risk”. 

However, they are just the tip of the iceberg. 

Without leverage risk, the downturn in 2009 would not have been nearly as serious. Although borrowing money can aid us in making investments (a house is a perfect example), there are limits. When we borrow too much (whether personal, corporate or governmental) we incur risk that an unexpected event may cause our cash flow to dry up—leaving us with no ability to service the debt. As such, leverage can quickly become a house of cards that comes tumbling down. 

The two types of risk that currently concern us most are inflation risk and interest rate risk. 

Inflation risk occurs when assets fail to keep pace with increases in the cost of goods and services. Over the past 40 years, after inflation the stock market has produced returns of more than 6% while the bond market has produced returns of negative 2.3%. With record low interest rates, it is not hard to realize that net of taxes and inflation, fixed income investments may seem safe—but actually carry significant risk. Since property taxes, food, health care and energy are all rising rapidly, this type of risk is hitting virtually all Americans.   

With the ten year Treasury bond paying a slim 2% interest, many investors in this type of asset face interest rate risk. Assume you buy a ten year treasury and one year later interest rates have increased. As such, the same Treasury bond now commands 6% interest. Obviously, your 2% is inferior to a 6% yield. If you go to sell your bond you will sell it at a loss to entice someone to buy it when compared to other options. Interest rate risk occurs when rates go up making existing fixed income assets inferior in comparison. 

For Texans, land is a love affair. However, unlike 100 shares of Coca Cola stock, there is not a constant stream of willing people wanting to buy your land every day. As such, when we most need to produce cash, liquidity risk—from land or any other non-publicly traded assets—rears its ugly head. 

Although this discussion exemplifies a few common types of risk, a smart investor will also evaluate the impact of political, currency, and credit risks too. 

Obviously, risk is not a one size fits all term. Given this, the more knowledgeable an investor is, the better equipped they will be to deal with the variety of risks facing all of their assets. 

Dave Sather is a Victoria CERTIFIED FINANCIAL PLANNER and owner of Sather Financial Group. His column, Money Matters, publishes every other week.