Intro to risk
In this section, we will talk about risk. We will see what it is and we’ll start relating it to the finance world.
What Is Risk?
The dictionary defines risk as “exposure of someone (or something valued) to danger, harm, or loss.” In simpler words, it is the possibility of you getting injured or losing something valuable.
From our definition, we see two main factors that can increase or decrease the level of risk:
- Possibility: the likelihood of something happening. The higher the possibility of something bad happening, the more risk.
- Amount: the amount to be lost or the level of injury.
Example of Risk:
If you are riding your bike on a highway, you know the possibility of getting into an accident is higher than if you are riding your bike on a trail, for instance. Also, you know that the level of injury possible is much greater on a highway since it is meant for motor vehicles to go at a fast speed, and a trail is generally meant to be used by pedestrians and cyclists for recreation. So we conclude that, logically, riding your bike on a highway has a higher level of risk than riding your bike on a trail.
Risk in Finance
In finance, the biggest risk is the possibility of losing money. Risk is a major factor to take into account when you are investing your money. It is really important to understand that there is a necessary trade-off between risk and return in most cases, and that risk-less investments are extremely rare. This means that when you expect high returns, they will necessarily be accompanied by a higher risk of losing money.
From this definition, we see two factors that can increase or decrease the level of risk of your investment:
- Possibility: the frequency of possible losses.
- Amount: the size of the possible losses.
Examples of Risk in Investments:
We will look at the two main types of investments and determine their levels of risk:
- Stocks: a stock is a risky asset, which means that its return is not guaranteed. When you buy a stock, its price fluctuates due to the forces of the market and it may or may not end up providing a profitable return on your investment. However, the expected return on stocks is generally higher than most other assets. Let’s look at a graphical example of a stock price behavior over time:
Every column in the above image shows the annual return of the stock for each year invested. We can determine the possibility of losing money by looking at the frequency of losses, which is four out of eight years. We can also determine the size of the losses, which ranges from -2% to -7% and it averages at -3.75%. On the other hand, if we analyze the upside, we can see how the stock gains 50% of the years at an average of 8.75%.
In summary, stocks generally yield high returns, which are accompanied by high risk.
- Bonds: also known as fixed income, are also risky assets. It is typically less risky than stocks because it is essentially a promise from a borrower (the issuer of the asset) to return the amount of the bond with a certain interest. However, it is generally not a risk-free investment for reasons discussed in further sections. Let’s look at a graphical example of a bond price behavior over time:
Every column in the above image shows the annual return of the bond for each year invested. As we did earlier, we see that the possibility of losing money is much smaller with bonds; because the frequency of losses is only one out of eight years. Also, the size of the loss is significantly smaller, at -1%. If we analyze the upside, we observe that we’ve gained money seven out of the 8 years at an average of 2.57% per year.
In summary, bonds typically yield lower returns and are less risky than stocks. Hence, they are safer investments.
To further demonstrate the effects of risk in those two cases, below we combined them into one graph, where the blue line depicts the Stock’s performance and the yellow line represents the Bond’s performance over the same period of time:
The Bond grows steadily all throughout the 8 years to end up yielding a total 17% return. While the Stock had a much bumpier ride, it started losing money, then it surged significantly to, then, start losing money again, then gained and then lost. That bumpiness is called volatility, which is also known as risk. As we can observe, the Stock’s performance at the end of the eight-year period is not that much better than the Bond’s. What would happen if the period ended at six years instead of eight? The Stock would have yielded a slightly lower return than the Bond, which is common in times of crisis.
We can conclude that high expected returns can be great, but it is crucial to take control of risks and know how to minimize them, which will be explained in later sections.
In the next segment, we will start talking about portfolios, allocation and how to invest.