Chapter 12 – Risk and risk management

Risks of Share Investments

Put very simply, the risk of an investment refers to the potential for an investor to lose some or all of their investment amount.

All investments face three broad types of risk: systemic, specific and sector factors. The relationship of each of these types of risk to the share market is discussed below.

Systemic factors affect the whole share market. They tend to be out of the control of individual players within the market, and are often out of the control of the market as a whole. Consider the terrorist attacks on New York City in September 2001. Trading on the New York Exchange was suspended for some days, and a sharp downturn followed the resumption of trade as investors sold their shareholdings and purchased more secure investments. The effect was felt, to a lesser extent, in Australia, as the All Ordinaries index fell from a level of 3183.3 points at the close on September 11 to a level of 2867.5 points on the 24th September 2001. This represented a fall of almost 10% in two weeks. The share prices of most companies on the exchange were affected.

Sector factors affect a particular sector of the market. Again, they are outside the control of the market. An example is the effect of fluctuations in the Australian exchange rate on resource stocks that trade in $US terms. Increases in the value of the $A against the $US will tend to drive down the share price of these companies, as their revenue will decrease in $A terms. The reverse happens with a fall in the value of the $A.

Specific factors affect a particular stock. The effect of these factors is felt only on the stock to which they refer. For example, in the week of 16 August 2010, the price of Telstra shares dropped from $3.29 per share to $2.92 per share, a fall of 37 cents per share, or 11.24%. The fall was attributed to a change in the way customers were using telephony, with the relative importance of fixed line services, in which Telstra had a large market share, falling in favour of mobile services, in which Telstra’s market share was less.

Shares are typically referred to as risky investments as the price at which shares trade is quite volatile over time. Consider the following graph which shows the value of the S&P ASX 200 Index over the 12 months to February 2016 (thanks, Google!). 

As the graph shows, the index reached as high as 6,000 points around April 2015, before falling below 5,000 points in January 2016. 

The volatility of the share market gives rise to what is known as timing risk. Timing risk is the risk that an investor will buy when prices are higher than at other times and/or sell when prices are lower than at other times, thereby reducing their capital return. Timing risk can be managed, as discussed below.

Managing Risk 

As the graph showing the one-year results of Australian shares above shows, share markets can be volatile (ie high risk), especially in the short-term. While share market risk can be high, history suggests that this risk can be effectively managed. Historic data shows that share market risk is at its greatest when investors invest in the shares of a small group of companies (or even just one company), and where the investment is held for a short time/sold at a pre-determined time. By avoiding these factors, investors can significantly reduce the risk of share investments.

The main two methods by which risk can be controlled are diversification and the adjustment of investment time frames. These two methods are discussed below. 

Diversification

In investment, an investor is diversifying whenever they increase the number of different investments they hold. In addition, when the different investment assets held are also different in type (eg shares versus property), then diversification is increased still further. 

In share investment, ‘diversification’ means holding shares in more than one company. Diversification allows the investor to reduce the risk that their entire portfolio will be harmed by risk factors that are specific to just one or a small group of companies. So, diversification reduces specific risk (n the case of owning shares in two or more companies) and sector risk (in the case of owning shares in companies operating in two or more sectors).

If a specific factor reduces the price of a share of a particular company, and that company’s shares are the only ones held in a portfolio, then the effect on the entire portfolio will be substantial. If the company is one of two companies whose shares are held in the portfolio, then only part of the portfolio is affected by the factor. For the whole portfolio to be affected, all the shares would have to be affected by separate specific factors, at the same time. The probability of specific factors simultaneously affecting the share price of two or more companies is less than the probability of them affecting the share price of just one company. Therefore, diversification reduces the probability that the whole portfolio will suffer from specific factors. 

The prospect of specific factors driving a share price down is known as a ‘downside risk.’ Of course, specific factors also cause increases in a share price. This prospect is an ‘upside risk.’ The probability of two or more shares being positively affected simultaneously by specific factors is also lower than the probability of just one share price being affected. So, diversification can also reduce upside risk. That is, diversification can reduce returns, as well as it reduces losses.

Proponents of diversification typically argue that the strategy is more likely to be of benefit to the investor. This is because a negative event can have a disproportionate impact on the investor’s portfolio. History shows that the average Australian share provided an average positive return of 9.4% across the twenty years to 2014. (There were years of negative returns, which are addressed below). Simple mathematics suggests that the more shares an investor holds, the more likely they are to achieve the average return. This is particularly the case where the shares are drawn from different sectors.

This means that by diversifying, the investor is likely to receive a return that is closer to average. Using history as a guide, the average return is likely to be positive. So, diversifying is likely to result in a positive return. Therefore, while the investor avoids the upside risk that the one share that they invest in might produce a large positive return, a diversified portfolio can nevertheless expect a positive return. Therefore, while diversifying might reduce the potential for large gains, it still creates the potential (perhaps even the likelihood) for solid positive gains. At the same time, diversifying reduces the potential for large negative gains.

The Limits of Diversification

Diversification within a share portfolio helps the investor to manage specific risk and sector risk. Specific risk is the risk that a particular company will perform poorly. When thinking about the share market, sector risk is the risk that all assets within a sector (for example, the banking sector of the share market) will perform badly. Sometimes events occur that affect all the companies within a sector. For example, an increase in interest rates will usually reduce the amount of money being borrowed. This would reduce the profits of companies within the banking sector of the market, and thus may have the effect of reducing the return on their shares. For diversification to be effective in managing sector risk, the investor must ensure that they hold shares from more than one sector of the share market.

Diversification within a share portfolio will not help the investor to manage those risk factors that impact upon the entire market. Within the share market, this risk is known as systemic risk. Examples of systemic risk include ‘shocks’ such as the World Trade Centre attacks on September 11th 2001. These attacks caused selling in all sectors of the share market, reducing prices in all sectors. While diversification within a share portfolio will not help manage systemic risk, systemic risk may be manageable by prudent use of investment timelines. This is discussed below.

Investment Timelines

Over the very long term, share prices tend to rise: on average, Australian shares produced an average return of 9.4% in the twenty years to 2014. But this is a long term average: over shorter periods, prices can be quite volatile. While most of these price changes are small, from time to time larger changes occur. These large changes can be the result of a one off ‘surprise’ for the market, where the price moves suddenly in one direction, or the result of the cumulative effect of many small changes. Either way, a share price can vary substantially over time.

This creates levels of ‘timing risk,’ for both buyers and sellers. Timing risk is essentially the prospect of buying before prices fall and/or selling before prices rise. The presence of timing risk creates a particular challenge for an investor who wants to maximise the high rates of very long term growth that can be enjoyed in the share market. If an investor ‘buys high,’ they reduce the long term compounding effect of their shareholding.

The main way to manage timing risk is to use a technique commonly known as ‘dollar cost averaging’. The Vanguard Australia Investment Dictionary, which is no longer online, defined dollar cost averaging as follows:

Practice of investing a set sum in shares or other growth securities at regular intervals, regardless of whether prices are increasing or decreasing. In this way, more securities are bought when their prices are low, and fewer when their prices are higher. Dollar-cost-averaging also means that the investor is not attempting to time the market – that is, trying to pick the best time to buy or sell.

The principles of dollar cost averaging are in many ways the same as those for diversification – indeed, dollar cost averaging is often referred to as ‘diversification of time,’ in the sense that the investor prefers to invest small amounts at different times rather than a large amount at a single point in time.

The Dover Group