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The Definitive Guide to Investment Risk

 

There really are only two basic things you can do with your money to generate returns: either you acquire assets at a price in the hope that the value will increase over time, or you give your money to someone else, who pays you interest for the term of the loan. Everything else is just a derivative thereof and no, there are no other magic investments that will give you anything other than risk to the upside or protection from the downside. As such, the entire definitions of asset classes, the descriptions of investment strategies and the use of products need to be put into context of which category of risk they really belong to.

 

For the most part, investors have become very comfortable with using stocks and bonds as proxies for the entire investment universe. But as both are listed on exchanges, they also bear some of the same risks (foremost market risk), even though they are by definition very different. Worse, is grouping everything else into a third category, aptly called “alternatives” and expecting any sort of benefit in diversification. Remember, no matter what you do, you are still either taking price or credit risk.

 

Therefore, the trick is not to look for something that doesn’t exist, but to break down the core risks into different forms thereof. For credit risk, that means we lend our money to others and we earn different yields for the risks (of default) we take on. The most common forms of credit risk are government bonds, which are backed by countries and as such (generally) are considered low risk. Then there are corporate bonds and loans with varying degrees of security. Lastly, there are loans against specific assets or projects (structured), whereby the risk is very concentrated and commensurately the return expectations are also higher.

 

For price risk, we can buy assets for growth and the risk is that prices will fall (on an absolute basis). The way to protect against this is to make investments that will benefit when prices go down. Putting this together, we can buy one and sell another asset at the same time to take advantage of mispricings. The risk is that the spread between the two asset prices moves apart (on a relative basis). Finally, we can also speculate on specific prices, whether by view or event. The risk is that the price won’t get to where we want or that the event does, or does not occur.

 

The investment universe may be the same for everyone, but only by understanding which strategies are alike or different from the next, can we manage our portfolio risk very precisely. By allocating into all six different categories of risk, we are truly diversified.

 

In the coming weeks, we will take a more detailed look into all of the six core categories that make up price and credit risk, starting with Government Credit in our next post.

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