What does it mean and how do you manage investment risk?
The risk of the investment can also be summarized very briefly, with you get significantly lower than expected results.
How can investment risk be grouped?
Of course, your investment portfolio as a whole is affected by all types of risk, so one or the other cannot be ruled out. Whether you have read on other financial portals or here on the Silver Moon page about the specific risk of a given investment instrument for a given instrument, they can be, without claiming to be exhaustive:
- counterparty risk
- credit risk
- risk of default (bankruptcy, serious liquidity problem)
- country risk
- etc.
If you read a description of any mutual fund, you can read a versatile compilation of these, so now we look at a different approach. The basis for grouping is risk management.
Market risk
Typically, macroeconomic processes that affect the exchange rate of a wide range of investment products.
E.g:
- inflation
- change in economic growth
- a significant and lasting change in investor risk-taking
This type of risk not really can be eliminated even by diversification, as almost the entire range is affected.
Individual risk
For the most part, it only affects the price of that particular investment.
E.g:
- individual decisions about when to buy or sell
- portfolio weighting, i.e., how much you buy
- only events related to the given device (eg something happens to the issuer)
These risks only affect the given investment or other investments based on the given investment, accordingly it can be reduced to any level by diversification.
How to manage investment risk?
Diversification
Then all you have to do is invest in several different areas and even invest your money in different assets. Then the better return on one asset compensates for the worse return on the other asset.
This can happen in several ways, e.g.
- division between assets: in addition to shares, you choose an asset that reacts differently to the given effect (eg gold and equities) or a lower-risk security (eg government bond, corporate bond), so if the share price falls, not your entire investment’s value decreases.
- territorial diversification: you can expect profits in those geographical areas where economic recovery is needed (you can also read about this in the August 2021 investor overview), but you can’t predict in advance which stimulus package will have a greater impact.
- cross-industry sharing: one economic effect favors one industry, not another, so you can even choose from the same investment instruments (eg stocks) to create a diversified portfolio by choosing from several industries
You can also create a diversified portfolio using mutual funds, after all, you may not have chosen many assets (maybe just one), but there are a number of securities behind it.
The relationship between diversification and portfolio risk was already discussed by Harry Markowitz in 1952, for which he also received the Nobel Prize.
Use of long – term investments
For an average investment, the daily returns are typically not too closely related to the previous day’s returns. That is, you won’t be able to “predict,” but in many cases, you won’t be able necessarily even estimate of what to expect the next day.
Then if you look at the exchange rate in the long run, you will see that the market is basically going up. That is, worse returns for shorter periods are offset by better returns for longer periods.
This is nothing more than diversification over time.
Reason for time diversification:
The standard deviation of the return for the period varies in proportion to the root of the length of the period, while the total return for the period is a linear function of the length of the period.
Before you run away, here is the same but simplified:
If your investment returns steadily at 10% over a period of time, it will return 20% in twice as much time, while the exchange rate deviates less and less from the level of expected returns. This will bring the actual return closer to the expected return in the long run.
Knowledge of one’s own risk tolerance
If you know your own risk tolerance, you will know which tools are right for you and will help you achieve your goals, and which ones are not advisable for you to use.
You may have a burning need for the returns of an asset with a higher return outlook, or it “just” sounds good that you are able to reach that much, but you only know that if you are in the right environment and used properly. That is, if it is appropriate for your goals, capabilities, and preparedness, there is a good chance you will achieve a nice result with it, otherwise it is likely to only cause harm but at least annoyance.
Conduct a test to assess your own investor profile, including your risk tolerance. Fill it out to find out which tools are right for you:
How to measure investment risk?
To be able to measure, it we must know what we’re looking for.
In some places you hear that risk is nothing more than the slope of the yield curve. However, this is not the case at all. If you recall, in the period before 2010, 10% interest rates were not uncommon in banks either, which was typically nothing riskier than the current 0.5% annual interest rate.
After all, at the bank interest rate, the average yield at any given time was the pre-set value, so you weren’t too surprised at the end of the investment period.
What we are looking for is nothing more than a deviation from the average.
Standard deviation (sign: σ)
Shows the deviation from the average values for the given period.
The greater the deviation from the average, the greater the volatility, and with it the risk of the investment.
Variance (sign: σ2)
This is nothing but the square of the standard deviation. You can see that there is a relationship between the two, so high standard deviation also means high variance, which shows high risk.
While the standard deviation can be negative, after raising to the square you will only see positive values, so it is easier to observe the trend of the deviation.
Investment risk metrics
Maximum drawdown
It shows how much loss you would have faced if you had entered at the highest point of the period under review and then sold your investment at the end of the period.
Calculation:
(Maximum exchange rate for the period / end rate for the period) – 1
The maximum value of this indicator can be 0%. In the image of the BUX index above, you can see that if you sell your investment at the very end of the period, you are right there at the maximum. You can also see from the formula that if the highest exchange rate is also the last, then the value of the fraction will be 1, subtracting 1 from this, you get 0%.
When calculating this indicator, only the two points shown are important. That is, even if there is a significant decline in the meantime, it does not matter here. If you want to calculate, it is the last time of another period.
Beta (β)
The β shows the average percentage change in the value of an investment when the market shows a 1% change.
That is, as long as you can reduce individual risk through diversification, the risk expressed by β should be tolerate by all investors.
We always compare the β of each investment to the market, so the market β is always 1, after all, we compare the change in the value of the market to itself.
Interpretation of β values
- Greater than 1: the investment has a higher than average risk
- 0-1: although the investment is risky, its level is below market risk
- 0: the investment has no market risk (at least measured for that market), i.e. it does not react to movements. It is not yet considered risk-free, as it still has a unique risk.
- -1 to 0: moves in the opposite direction to the market, but less risky than the market
- Below -1: moves in the opposite direction to the market with above average risk.
Negative β typically has countercyclical investments (e.g., gold) that are affected by market effects to the contrary.
Distortion of β
In the case of examining less liquid markets (e.g., real estate-related markets), in the absence of adequate turnover, the effect of market change may appear only with a significant delay. Even if it shows up, it may not be reacting to the real and justified extent either (after all, who remembers what it was half a year ago). β is also an important indicator in these markets, but calculate that you are probably working with a past, no longer current data.
The β of the portfolio
Weighted average of the betas of the investments that make up the portfolio.
Expanding a positive β investment with countercyclical investments thus makes it possible to reduce portfolio risk.
Questions:
- How do you manage the risk of your own investment?
- What do you consider to be your primary risk?
- What role do stocks play in your own portfolio?
If you have any questions, please contact us so we can help you.