Investment risk is simply the chance of losing your assets. There are many ways to perform that effortless feat.
Business risk is the Achilles' heel of investors who view a stock as a collection of numbers (e.g., yield, price/earnings ratio) without going behind the numbers to understand the business that generates them and what could go wrong with that business. Business risk may center on assets, as in the case of a department store that finds itself with worthless inventory after a fashion change. It may center on income, as when a steel company's profits drop sharply during a recession. Whatever its form, business risk is the first place for an investor to start.
Financial risk also comes in two forms: leverage and liquidity. There is a big difference between a company that earns high returns on equity because its business is excellent and one that earns high returns because it has leverage a mediocre business with large amounts of debt. An investor in a leveraged company often will do well in good times, but at the cost of greater risk if something goes wrong.
Liquidity is the other part of financial risk. A company with surplus cash is unlikely to go bankrupt. By contrast, Penn Central showed a large net worth right up to the day it went bankrupt because it ran out of cash. All companies have one of two problems with respect to cash: where to get the cash they need or how to spend the surplus cash they have. A company with the second problem has a low amount of financial risk.
Price risk is the chance of paying too much for a stock. This mistake is most likely when an investor buys a stock favored by conventional wisdom. In investing, the majority is usually wrong, so after a stock becomes popular, an intelligent investor generally will sell it rather than buy it. Even excellent companies are valued excessively from time to time so an investor should be sensitive to price as well as to quality in what he buys.
Inadequate diversification is a risk that bedevils even professional money managers. It is not as simple as making sure that your stocks are not all chemical stocks or drug stocks. Every few years, the stock market becomes entranced with an idea that cuts across normal industry groups and raises the prices of stocks favored by that idea to unsound levels. For example, in the early 1970s the idea of quality growth stocks favored fine companies like IBM, Merck and Disney. Many investors thought that a portfolio of these companies was diversified because their businesses were unrelated, but in fact the stocks rose together up to 1973 and crashed together in 1974.
Market risk is a major part of modern investment theory. Although the mathematics may be complex, the basic idea is simple. Movements of the broad market of stocks have a major influence on the movements of particular stocks. The larger and more diversified an investor's portfolio, the more likely it is to perform in line with the stock market as a whole. Therefore, unless an investor concentrates on a few special situations, he should consider the prospects for the stock market as a whole because movements in the market may have a major impact on what happens to his investments, particularly over short periods of time.
People fear the tiger that bit them last, but that is seldom the tiger that bites them next. The relevant risk of the past generally is not the relevant risk of the future. For example, prudent men in the early 1950s remembered the Great Crash and vowed never to own stocks again, just as the great postwar bull market began. Not owning stocks was the major risk in the late 1960s after years of excellent stock market performance mesmerized investors into thinking the market could go in only one direction. Many prudent men in trust departments and pension funds invested their assets in stocks just in time for the next three bear markets. An investor should learn from past risks but should realize the future may be very different.
Emotional risk receives little attention, but it may be the most important of all. The anguish of investors in a bear market and the euphoria of the same investors in a bull market must be seen to be believed. People in the grip of anguish or euphoria seldom make coolly rational decisions about investment value. The problem is compounded because most stockholders invest their egos along with their assets, so it is twice as painful when a stock market that cares for neither assets nor egos decimates them both in a bear market.
An example of emotional risk is becoming gunshy after a loss. The essence of investing is making present decisions about an uncertain future based on incomplete information. Under those circumstances, even the best investors make occasional mistakes, but they don't let occasional mistakes bother them emotionally. Investing is a batting-average business, and every investor should remember that even Babe Ruth struck out occasionally.
Purchasing power risk has become far more relevant during this inflationary era. Even Treasury bills, which are riskless as to their nominal value, are very risky as to their real value after allowing for inflation, particularly on an after-tax basis. This points out the unpleasant fact that all investments have some form of risk to them.
The investor is like a trooper in the Light Brigade surrounded by cannons thundering from the heights of Balaclava. He is surrounded by risk, and there is no way to avoid it. The relevant choice is not a decision to avoid risks, but a decision about which risks to take.