How to Measure Investment Risk

When you're talking about investment risk, what do terms like "low risk" "medium risk" or "high risk" really mean? The question you need to answer is, "Can I lose my money?"

To answer this I classify investment risk on a scale of one to five, with one representing a low risk, safe, guaranteed investment, and five entailing the highest risk; the risk that you can lose all of your money.

You take on higher levels of investment risk for the opportunity to earn a higher rate of return than what you can receive using only low risk investments. This makes sense. Yet, if you don't understand the risks your money is exposed to, it can catch you off guard and instead of making more, you'll end up losing. Understanding the categories below, and the investment returns you might expect from each category, will help you avoid unnecessary investment risk.

1. Low Risk Investments, Safe & Guaranteed

When you have no risk that you could lose principal, you have a low risk investment. This is accomplished with safe investments; investments that often have a guarantee backed by the U.S. Government.

2. Low to Minimal Risk Investments Like Short or Intermediate Term Bond Funds

There are numerous types of bonds (government, corporate, municipal), each with its own degree of investment risk. Risk varies depending on the type of bond, and the term of the bond.

The term of a bond refers to the length of time until the bond matures, which is when the principal must be repaid. With a long-term bond your money may be tied up for ten, fifteen or even twenty years; with a short term bond, it may be only one to two years until your principal is safely back in your hands. The longer the amount of time before your principal will be returned to you, the greater the risk.

3. Moderate Risk Investments, A Blend Of Stock and Bond Funds

You can find some middle ground; a moderate level of investment risk that falls between the safety of risk level one and the extremes of risk level four. You find this moderate level of risk by blending together higher risk investments, like stock index funds, with lower risk investments, like short and intermediate term bond funds. A balanced fund will do all of this for you.

4. High Risk Investments, Diversified Stock Funds

High risk investments like stock index funds are best understood by looking at a specific example.

An index is like a ruler. It measures the performance of a basket of stocks. One widely followed index is the Standard and Poor's 500 Index (S&P 500), which tracks the performance of five hundred of the largest publicly traded companies in America. These are companies like Proctor & Gamble, Microsoft, WalMart, Johnson & Johnson, GE, Pfizer and Exxon Mobil, just to name a few.

When you buy an S&P 500 Index fund, the fund owns a little bit of all five hundred stocks. If one of those companies gets in trouble, it has a minimal affect on your overall investment.

What about the odds of all five hundred of the largest companies in America going under, all at once? If that happens, we've got bigger problems on our hands than how to invest our money. For the sake of this discussion about risk, I'm comfortable saying you cannot lose all your money in a stock index fund. Yet you can experience times where your investment value will go down by 50%. For this reason, this type of investment is considered high risk, yet if you're in it for the long term, you've protected yourself from the risk of losing it all.

5. Extreme Risk Investments, Individual Stocks

Anytime you buy an individual stock or bond (unless it is a government bond), you take on a high degree of investment risk, as big companies can and do go bankrupt, and their securities become worthless. You have a tremendous amount of control over this type of risk.

Avoiding extremely high levels of investment risk is accomplished by spreading your money across several stocks and bonds. Picking your own securities and monitoring them on an ongoing basis is a lot of work, and requires a good deal of expertise, so instead of picking and choosing your own stocks and bonds consider using mutual funds, which do the work for you.

Most Common Mistake in Measuring Investment Risk

Most investors can tell the difference between a safe, low risk investment and one that's more aggressive. However, the biggest mistake I see investors make is they don't know the difference between a high risk investment, yet one where they could not actually lose all their money, and an extremely high risk investment, where there is the possibility of losing all one's money. That is the difference between item 4 and 5 above.

The limitations of financial ratios

Applying mathematical ratios to the figures in a company's financial statement can help you build a picture of how a company works, as well as alerting you to potential trading and investing opportunities.

Companies do not exist in a vacuum, however, and a number of external elements will make certain ratios more or less useful depending on the economic climate, government actions and market sentiment.

Even within a company, there may be events – such as the appointment of a new CEO or the launch of a new product – that are difficult for investors to foresee. Things like this can blow out of the water any trading decisions you have made based on analysis of old financial statements.

It is important therefore that you apply financial ratios with caution, remaining aware of their limitations and of other factors that could override them.

No two companies are the same

No two companies are exactly alike, and that is especially so when they are operating in different industries.

As discussed in the previous lessons, capital-intensive companies like airplane manufacturers rely more heavily on debt, have less liquid assets and tend to grow more slowly than, for example, software companies.

These factors will affect how ratios such as debt to equity or return on capital should be interpreted when you are deciding whether to buy or sell their shares.

Companies that carry a lot of inventory, which they can in theory sell quickly for cash, (retailers, for example) similarly require a different approach when interpreting things like the current ratio than when you are looking at a construction company.

Size matters

Companies also require a different approach depending on their size.

Small-cap companies often pay more for their debt than large-caps, and this will affect the way formulas like interest coverage ratios need to be interpreted. They also tend to have faster growth prospects, and this will change the way things like the discounted cash flow model are calculated.

A change in destiny

A company’s destiny can change with just one key event, making analysis of its historical performance virtually redundant.

When apple launched the iPod, for example, everything from its price to earnings ratio to the fair value that analysts assigned it changed dramatically.

A new CEO can also introduce dramatic changes at a company that will have been difficult for investors to factor in to their analysis ahead of the event.

New leadership at a company can trigger big restructurings, including whether it borrows more heavily or pays off debt and how it approaches other costs. Therefore, financial performance ratios in particular could undergo rapid change while other ratios such price to book may now become misleading.

Market sentiment and macro factors

Market sentiment can change very quickly and the risk appetite of other traders can have a big impact on the price of shares you have invested in, regardless of the fundamental factors you have studied when making your analysis.

Tolerance for risk can increase

There are times when investors have a stronger than usual appetite for risk – for example when an economy is expanding, interest rates are low and stock markets in general are climbing.

At these times they will be more prepared to take a gamble on companies that investors might normally ignore. This could include high-risk small-caps, or firms whose financial performance or health ratios are shaky.

This can quickly push up the share price of companies that based on your fundamental analysis you had decided to avoid investing in or, if you are a CFD trader, to short for a profit.

Risk appetite can decline

Conversely, if other traders become risk averse, a stock that you have analysed in detail and decided is fundamentally strong may be punished along with its peers as investors exit stock markets.

Economic cycles can change

Similarly, a change in the economic cycle, in taxation, in government legislation or even the weather can affect individual sectors disproportionately and drive share prices in directions that may seem irrational if you focus exclusively on companies' financial statements.

The impact of the outside world

A company's share price is affected by much more than the business performance of the company itself.

The price of a share is driven by whether traders want to buy it or sell it, and in what volumes.

If traders like the look of a company's profit, leadership or future growth prospects and they think these factors will push up demand for its shares, they will be more likely to buy those shares in the hope of selling them for a profit later on.

If they are unimpressed with a company's health and prospects and think this will push down demand for its shares, they will be more likely to sell them.

The bigger picture

However, this is only one part of a much broader picture. A huge variety of factors affect a company's share price, many of them beyond the company's control.

Government actions can change the business environment a company operates in, making it easier or harder for the company to compete with rivals and earn a profit.

The general health of the economy can stimulate or decrease demand for a company's products and services, as well as affecting traders' appetite for investing in risky assets like stocks.

Demand for shares in general can rise or fall depending on what time of the year, month or even week it is, especially as traders rely more and more on historical price charts to predict price moves.

Meanwhile, market hype driven by rumours, fashion trends, press coverage or a well-publicised IPO can push a company’s share price up or down, regardless of whether the attention is deserved.

Changes in the price of other assets can also impact share prices. Higher prices for a commodity like oil, for example, can push a company's share price up or down depending on whether it produces or consumes the resource.

Currency exchange rate fluctuations meanwhile, may make it more, or less, expensive for a company to import the goods it needs and more, or less, lucrative to export its end product.

As the world economy becomes more interconnected, geopolitical factors such as a change of government, a war or even the weather can also push around share prices – regardless of how far from a trader's home country these events occur.

Traders need to keep their eye on the wider horizon, factoring in all of the above when they are trying to determine which direction a share price will take next.