Risk is usually presented as a catch-all term for everything that could negatively impact the value of your investment. Managing risk exposure relative to expected return is a big part of what investment managers help clients with.
Let’s start with outlining the types of risk that you might face in a particular investment. These broadly fall into two categories: systemic risk and idiosyncratic risk. Systemic risk affects investments broadly. For example, the risk of inflation eating away at the value of your bank account affects the entire market. Similarly, the risk of a recession affecting corporate profits and the ability of firms and individuals to repay their debts affects most securities. Idiosyncratic risk is particular to the individual investment. Buying Tesla stock entails accepting the risk that the company fails to raise more money or sell more cars and collapses. It is a risk unique to Tesla though.
The important thing to understand about idiosyncratic risk, is that these types of investment specific risks can be reduced or effectively eliminated via diversification. If you have enough investments of a similar type, the unexpected positive surprises and the unexpected negative surprises balance each other out leaving your entire portfolio of investments exposed only to systemic risks. We’ll talk about how to minimize systemic risk in the next section.
So how does risk relate to return? Underlying every investment decision a person can make is the opportunity cost of making an alternative decision. You could keep your cash under your mattress, but the least risky alternative is to put it in a bank where you can earn more. Unless you believe that the banking system is nearing imminent collapse, this would probably be a good tradeoff. Likewise, you could leave your money earning next to nothing in a bank account and take on the risk that it doesn’t keep up with inflation, or you could invest in stocks or bonds or bitcoin or any other type of security. In each case, you make a tradeoff between the risk you’re willing to accept for a given amount of return relative to other investments and their risk / return profiles.
What you should generally expect is that risky investments should provide investors with a higher expected return; otherwise, why wouldn’t you take the less risky option for the same return? This difference between the risk-free return and a risky investment’s return is called the risk premium. Different investments carry different risk premiums and they can change over time. In the long run, here’s the risk hierarchy that you should generally expect:
- Cash - Your return on cash in your wallet is zero. Let’s call this the baseline.
- Money Market - Very short-term, extremely safe debt. Because this is meant to be paid back on a short-term basis, the risk you’re taking on is counterparty risk - the risk that the institution facilitating these investments cannot pay you back. This type of security has never failed in the modern era.
- Federal Treasury Bills - Government debt with payback periods of under 1 year. The 3-month T-Bill is usually considered a proxy for the risk-free rate because of the very low risk that the federal government cannot make good on its obligations in the near-term.
- Federal Government Bonds - US government debt is generally considered an extremely safe investment because of its trustworthiness and capacity to meet obligations by taxing the citizenry. The primary risk of government debt is from inflation because at worst, the government can always print money to pay back debt denominated in US dollars.
- Other Government Bonds - There are lots of different bonds either issued by governments institutions (foreign countries, states, counties) or agencies backed by governments (Fannie Mae, Freddie Mac mortgage bonds) are also considered safe under most circumstances for similar reasons to federal government bonds.
- Investment Grade Corporate Bonds - Bonds issued by corporations with strong track records of repayment and operating fundamentals that support their capacity to continue repayment in the future. Bonds are generally less risky than stocks because in the event of bankruptcy, bond investors are paid back before stock investors. Non-investment grade bonds are also called junk bonds. This debt tends to perform similarly to stocks because it gets paid back after other bond investors or is at higher risk of not being paid back in the event of a bankruptcy.
- Large Capitalization Stocks - Stock in the largest 500 publicly traded companies. Stock gets paid back after bond investors, but the stock in the largest companies is generally considered safer and more likely to produce consistent returns to investors than stock in smaller companies.
- Mid Capitalization Stocks - Stock in the next 1,500 largest publicly traded companies. These companies typically have a slightly riskier profile than large cap companies because they do not have the same scale as their larger counterparts.
- Small Capitalization Stocks - The remaining public companies have riskier profiles either because of their small scale or uncertain growth prospects.
- Private Equity - Private investments in stock or debt in companies that would otherwise fall into the mid or small cap category are generally considered riskier because of liquidity risk, the risk that you cannot extract your investment dollars from them easily. There are other types of private equity as well that have their own unique risks.
- Venture Capital - Small, speculative investments in high potential companies (like Farther!). Most of the value of these companies will be created in the future and the added uncertainty of future performance creates a riskier profile.
Connecting this back to what we cover in exploring the time value of money, the more risk there is in whether and how much you’ll receive in the future, the less valuable a promise of $100 in the future becomes. In order to compensate you for taking on risk in a promise of future payment, an investor must demand a return. The higher the risk, the higher the expected return must be over the risk-free rate. Put another way, the higher the risk, the more return you should demand for all of the things that go wrong between now and your future payment.
To sum up, you want to get paid back on anything you invest in right? How much you get paid back is related to how much risk you undertake. The difference in your payback from a risk-free investment to a risky investment is called the risk premium, and different investments have different risks and risk premiums associated with them.