In the simplest of terms, the “investment risk,” is a possibility of an investment bringing a result other than anticipated.1 You may lose some or all of your invested funds, even though you anticipate profit. You can also gain something, but less than you have expected. For example, you could have expected a return on investment of 5% but got only 2%. It is important to realize that every investment entails some risk and to understand the underlying reasons. We will discuss this further using an example of Irenaeus: the most unlucky investor in the world, who is also lousy when it comes to risk assessment.
The inflation risk or the purchasing power risk
Let us use an example from the book “Fundamental analysis” by John C. Ritchie.1 According to the example, we will assume that on January 1, 1967, Irenaeus deposited $1,000 into his savings account, and expected to maintain or even gain his purchasing power. The annual capitalized interest rate was 5%. Irenaeus kept his money in his bank account until the end of 1985. So, we can calculate that at the end of 1985 he had $2,526.95 in his account. Should he be happy with this result? At the same time, the value of the dollar fell to 31 cents as compared to 1967, when the account was opened. Thus, in 1985 the purchasing power of the original amount $2,526 was now only $783.35 in terms of dollars from 1967. Irenaeus underestimated the impact of inflation. He did not expect that inflation would be so high, so he had lost some of his purchasing power (i.e. $216.65 from 1967) instead of maintaining or gaining it.
Interest rate risk
Irenaeus decided to spend $1000 to buy bonds that pay 4% annually in interest. His colleague Arcadius made the right decision to delay his purchase of the bonds, because a few months later new bonds paid 6% in interest e.g. due to rising inflation. Arcadius spent $1000 and received $60 in interest each year, while Irenaeus received only $40 per year. If Irenaeus wanted to sell his bonds on the market, he would not be able sell them for $1,000 anymore. Why would anyone buy bonds from him and be paid merely 4% in interest, when bonds bought directly from the issuer would pay 6% in interest? So, to sell his bonds Irenaeus had to lower their price to pay the equivalent or more of the rate of return on the new bonds. In this case he would have to lower the price of his bonds to $650, for example. Any buyer would receive $40 a year for a one-time price of $650, so that the interest rate on the old bonds would effectively rise to 6.15%. Unfortunately, Irenaeus would lose $350 on sale. Of course, he could abstain from selling his bonds and wait until their redemption, but in that case he would earn 4% in interest instead of 6%.
Irenaeus, discouraged slightly by his previous failures, decided to invest in foreign real estate. He bought a beautiful seaside property, which he intended to sell at a profit. Roughly at the same time a socialist dictator came to power in the country. Pretty soon the property was nationalized and put into use by other people. Irenaeus lost all the funds he invested in the property. Of course, Irenaeus was extremely unlucky; political risk does not always involve such extremes as war or totalitarian dictatorship. Political risk may be associated with any political activities that have a negative impact on the economy and on the profitability of investments, such as economic regulations that negatively impact the economy, or instability of law causing increasing uncertainty.
What Irenaeus lacked in good fortune, he made up for in perseverance. And try not to ask where he got the money for all these endeavors — we simply do not know. Irenaeus had some Polish zlotys, so he exchanged them for dollars and started buying shares of some American companies. After a year the prices of shares bought by Irenaeus expressed in dollars increased by 10%. Irenaeus thought that his investment was a great success, so he sold his shares, exchanged dollars for zlotys and to his astonishment discovered that after the exchange he had less zlotys in his pocket than he had last year. It happened because Irenaeus did not take into account exchange rate volatility. Irenaeus bought $250 with one thousand zlotys. At the time, one dollar cost 4 zlotys. After Irenaeus sold dollars for shares, the value of the shares increased to $275, that is by 10%. Then he sold shares for dollars, and he finally bought zlotys with dollars at the exchange rate of 3.5 zlotys for a dollar — because the zloty strengthened against the dollar in the meantime. At this exchange rate, Irenaeus sold $275 and got 962.5 zlotys. Irenaeus’ luck would turn around and he would have gained money had the dollar strengthened against the zloty instead.
But our hero had yet another idea: he wanted to invest in artwork. Irenaeus bought a painting, hoping for its value to grow with time. And he was not mistaken: its value was actually steadily growing. Unfortunately, at some point Irenaeus urgently needed large amounts of cash. He decided to sell the painting, but he struggled to find any buyer. Although his painting was worth much more than he needed at the moment, Irenaeus failed to sell it quickly enough, so in the meantime he had to get a high-interest loan. The liquidity risk particularly applies to real estate, unpopular shares of companies, and others as well. Low liquidity assets are difficult to sell. And if you want to sell them quickly, you have to significantly lower your asking price.
Irenaeus’ next investment slip was that he let himself be deceived by the high interest rate on corporate bonds. He focused so much on the interest that he failed to investigate why the issuing company needed the money. It turned out that the company wanted to finance a very risky investment that eventually failed. The company got into financial trouble and defaulted on its obligations to Irenaeus.
The list of potential threats that await Irenaeus in the financial market goes on. He also has to watch out for business risk. For example, he can invest in a company that will make bad business decisions, fail to adapt quickly enough to changes, or have its reputation destroyed for some reason.12 If Irenaeus wants to buy financial instruments at the right moment, then he should also pay constant attention to the general market situation.3 That is not all. Many of these risks may occur at the same time. And so Irenaeus should think well before investing in anything. He should carefully consider each investment in terms of risk and decide whether he is willing to take it.
1 Risk is used here in the same way as economic practitioners understand it:
“In economics, we define risk as a kind of probability which, unlike uncertainty, can be estimated mathematically. Thus, it can be accurately determined in the same way as a coin toss. Economic practitioners use this term in a slightly different sense — with an additional negative overtone. They do not mean a mere likelihood of an event (a loss) occurring, but rather an unexpected effect of their actions, specifically the potential loss.“
2 Ritchie, John C. 1996. Fundamental Analysis: A Back-to-the-basics Investment Guide to Selecting Quality Stocks. Irwin.