Risk and Reward

Risk is exposure to potential liability. In finance, risk refers to the potential downside of an investment’s actual gains relative to the expected return (uncertainty). Generally, high uncertainty indicates a high level of risk. Though, financial risk isn’t necessarily bad; that’s where the risk-reward tradeoff comes into play: “high risk, high reward, ” and vice-versa.

The Risk-Reward Tradeoff

The risk-reward tradeoff makes intuitive sense when you think about it in a simplified example.

Imagine a global gold mining company, Oswald Resources, that has been running for just under a decade and recently got a hot tip about a potentially lucrative goldmine region in South Africa. Oswald, the CEO of Oswald Resources, gets very excited and pours all available funds and even takes on an extra $50 million loan to finance an open-pit mine in the targeted district. Things could go one of two ways; the hot tip could have been credible and Oswald may hit the goldmine, or, Oswald may have been fooled and suddenly be in a world of financial hurt. If things go well, Oswald Resources may earn billions and expand into an even larger business, and make investors very happy. If not, then bankruptcy may become much more likely, their credit rating would see a steep decline, and investors would lose a lot of money.

At the same time that Oswald is banking on this highly speculative venture, Olivia is running a laundromat business, Olivia’s Laundry, with more than 35 locations across Ontario. She has been in business for almost 4 decades and is now on track to open up a new location every year for the next 5 years due to a steady 5% growth rate each year since 2012. Common shares of the business currently offer a 2.5% dividend yield.

As you may have guessed, Oswald Resources would be considered a far more risky investment than Olivia’s Laundry. This is because Oswald has all of his eggs in one basket, has a relatively new business, and no back-up plan. In contrast, Olivia’s operations are diversified across many locations, there is a track record of steady growth, and there is a plan for expansion. Don’t be fooled, however; there is no such thing as a risk-free business. Though it may be less obvious, Olivia’s Laundry still has risk, be it less than Oswald’s. One example of a risk she faces is the potential for an increase in utility bills in Ontario, which would increase her bottom-line and reduce profit margins. This could hinder her plans for expansion.

The Investor Perspective

One of, if not the most important things that every investor needs to realize, is that risk is not inherently bad, nor is it inherently good. Risk is an instrument that should be used strategically and managed based on the investor’s circumstances. This is where time horizons and the concept of opportunity cost comes into play.

April is 60 years old and expecting to retire within the year. She has just over $1 million in savings due to smart budgeting practices. Sadly, her investing practices were not as smart, as the cash has been left sitting in a savings account, slowly losing value from inflation.

Toby is a 23-year-old student who just started working his first long-term job at a paper company as a human resource representative. He wants to start saving and investing for his retirement, which he approximates to be ~40 years away.

In April’s case, it makes sense to buy more shares of Olivia’s Laundry over shares of Oswald’s Resources. This is because her time horizon is much shorter as she will need to sell her assets to materialize unrealized profits for income. The dividend payments will also support an income stream. Investing in Olivia’s Laundry gives her less upside for her investment, but in her situation, the lower risk — and thus lower downside — makes it worth it.

For Toby, it would make sense to buy both shares of Oswald’s Resources as well as shares of Olivia’s Laundry. Toby is young, has a long investment horizon of ~40 years, and does not have any money saved already, therefore he can sustain a higher level of risk relative to April. His longer investment horizon means that even if Oswald’s Resources doesn’t end up finding a gold mine in South Africa he can still afford short-term losses as long as they get it together in the long run.

If Toby were to put all of his money in April’s Laundry, and Oswald’s shares ended up skyrocketing, he would have missed out on a huge opportunity. The money he would have lost would be referred to as the opportunity cost. This is the term used to describe the invisible cost incurred when one makes one decision over another. Think of it like when you choose to watch Netflix instead of working a shift at your job. The money you could have made is essentially how much money you lost by watching TV. If you value watching Netflix the same or more as that opportunity cost, then it is worth it. If not, then it is not the right decision. In April’s situation, the potential opportunity cost can be argued to be worth it for her due to the lower risk. Opportunity cost is considered intangible because it is subjective. Many businesses still choose to hire strategists and economists to minimize their opportunity cost.

Types of Risks

Pure risk is a risk that can only result in a loss, whereas speculative risk is a risk that can result in either a gain or a loss. Speculative risk is the type that is being referred to when we say “high risk, high reward”.

Systematic risks are those that affect the entire market such as political, inflation, interest rate and currency risks. They are not unique to a specific company as they impact a large portion of the economy, usually spanning multiple sectors. This risk is measured with the beta(β) ratio which measures asset volatility relative to some benchmark like the return rate of an index over a period of time.

Unsystematic risks only affect a specific company or industry. Factors that could affect this could be product recalls, industry-specific regulatory changes, new competitors, etc. The following are a number of the most common unsystematic risks a company may face:

Business / Model Risk

Business risk refers to the potential for the company to become unviable due to an outpacing of expense, not enough revenue, etc. This may be because of irresponsible management decisions or it may be because the business model itself is not sustainable. Another reason may be because the financial models that business is using to base decisions upon is unreasonable or inaccurate. The housing market crash of 2008 is a perfect example of what happens when risk exposure models are not representative of reality, and that the market can remain irrational for a long period of time. This is called model risk.

Default / Rating Risk

Default risk is the potential that a company won’t be able to pay off debt obligations to its creditors which could result in bankruptcy. Rating risk is the possibility that credit rating agencies decrease a company’s credit rating, which directly increases the cost of borrowing and in turn affects market sentiment.

Legislative Risk

Legislative risk is the chance that the government takes action which adversely affects the business. This can include everything from higher taxes to an antitrust lawsuit or even simply more strict regulations.

Headline Risk

Headline risk is the potential that headlines from the news media hurt a business and/or its reputation. Headline risk often accompanies some other form of risk, adding fuel to the fire as it can cause the market to overreact.

Liquidity Risk

Liquidity risk is the risk of the investor not being able to sell an asset for cash when he/she wishes to due to low trading volume. This makes the asset worth less to the investor.

Handling Risk

Understanding how a business can deal with risk can help investors better understand situations and how to respond appropriately.

Avoidance

Avoiding risk is something that a business may decide to do if the risk is speculative and they believe that doing so will reduce their opportunity cost.

Retention

Retaining risk is the opposite of avoidance as with this method, the business decides to assume the risk. If it is a pure risk, the company has no choice but to do so.

Reduction

Reducing risk involves taking measures to reduce a company’s exposure to an uncertainty. For example, a store may install cameras to reduce the chance of theft.

Transference

Transferring risk means to reassign risk from one entity to another. The most common example of this is insurance, where the insurer agrees to offset the loss incurred by the business in case some event occurs, in exchange for regular premiums paid to the insurer by the business.

Hedging Risk

Managing all of these risks and finding the best balance of risk and return is where hedging risk becomes important. Hedging is to invest in a security with an inverse correlation with the price movements of another asset or portfolio to offset losses. That means that the hedge security decreases in value as the related security increases, though a perfect hedge is hard to find. A hedge can be thought of as an insurance policy where risk is reduced in exchange for reduced potential profits.

If you recall from the example of Toby, it was recommended that he buy more shares of Oswald’s Resources than Olivia’s Laundry, and not only Oswald’s shares. This is a form of hedging the overall portfolio’s risk. By diversifying with a portion of the portfolio in a safer investment, Toby has less risk than if he only had shares of Oswald’s Resources. Intuitively, the tradeoff is that his potential profit is reduced as well.

Derivatives are a more useful form of hedging as they can truly have an inverse relationship with the price movements of another asset. To learn more about derivatives, you can read investBETA’s article on them here. The following is an example of a better way for Toby to hedge against his investment in Oswald’s Resources:

Toby buys 100 shares of Oswald’s Resources at $100 per share, costing him $10,000. He also buys put options on the stock for $50 with a strike price of $80 that expires in 12 months. If the share price falls below the strike price of $80 within the 12 months, Toby can still sell the shares at that $80 strike price.

The maximum loss from the option that Toby could incur would be the amount that he paid for the option which is $50. This would be if the share price never traded below $80 before the expiration date. The maximum theoretical net profit that he could earn would be if the share price fell to $0. This would result in 100 shares $80 per share, which is $8,000, less $50, which would leave you with $7,950.

The put options act as a hedge for Toby, decreasing in value when Oswald Resources shares increase, and vice versa. This is why derivatives like put options are commonly used to hedge investments.

Another way that many investors choose to hedge is to include long-short pairs in their portfolio, also known as pair trades. This is where one security is bought or longed, and another security is borrowed then short-selled or shorted, meaning to bet-against. This strategy is most effective to get rid of systematic market risk and was developed by researchers at Morgan Stanley in the ’80s. An example would include buying shares of the airplane company Boeing whilst shorting an airplane ETF. This should in-theory get rid of fluctuations in the airplane industry as a whole within your portfolio, leaving you with only a “net” position in Boeing over its peers. Thus, you would be betting in Boeing outperforming the rest of the airplane industry, and not in the company as well as the industry in which it resides.

Risk is one of the most important aspects when considering an investment, and must not be overlooked. Before giving a company a single dollar of your hard-earned money, make sure to analyze the risks that the company faces as well as those that you would face as a potential investor. A good company should be managing these risks appropriately and a good investor should be hedging against them when buying.

Hopefully this article helped you learn how risk works as well as how to identify and manage it properly. If so, be sure to look over some key takeaways and at some next steps you can take to support us and further your learning!

Key Takeaways

1. Risk is exposure to potential liability
2. Financial risk refers to the potential downside of an investment’s actual gains relative to the expected return (uncertainty)
3. High risk = High reward
4. The higher an investor’s time horizon, the more risk the investor can afford
5. Pure risk = only downside, Speculative risk = could go either way
6. Systematic risk affects the larger market, unsystematic risk is targeted to a small portion or just one company
7. Risk can be handled through avoidance, retention, reduction, and transference
8. Investment risk can be managed by hedging through diversification, derivatives, and pair trades, among other things

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