Risk - Money, Banking, and Financial Markets , Fourth Edition (Stephen G.

Cecchetti, Kermit L. Schoenholtz)

The dictionary definition of risk, the “possibility of loss or injury,” highlights

the perils of putting oneself in a situation in which the outcome is unknown. But
this common use of the word doesn’t quite fit our purposes because we care
about gains as well as losses. We need a definition of risk that focuses on the
fact that the outcomes of financial and economic decisions are almost always
unknown at the time the decisions are made. Here is the definition we will use:
Risk is a measure of uncertainty about the future payoff to an investment,
assessed over some time horizon and relative to a benchmark.
This definition has several important elements.
 First, risk is a measure that can be quantified. In comparing two
potential investments, we want to know which one is riskier and by
how much. All other things held equal, we expect a riskier
investment to be less desirable than others and to command a lower
price. Uncertainties that are not quantifiable cannot be priced.
Quantifiable risk allows investors to compare investments, price them accurately,
and make decisions based on measurable uncertainty. A riskier investment, all
else equal, commands a lower price to reflect the additional uncertainty. On the
other hand, risks that cannot be quantified cannot be incorporated into pricing
models, leading to a situation where investors may shy away from the investment
due to the unknown factors.
 Second, risk arises from uncertainty about the future. We know that
the future will follow one and only one of many possible courses, but
we don’t know which one. This statement is true of even the simplest
random event—more things can happen than will happen. If you flip
a coin, it can come up either heads or tails. It cannot come up both
heads and tails or neither heads nor tails; only one of two
possibilities will occur.
 Third, risk has to do with the future payoff of an investment, which is
unknown. Though we do not know for certain what is going to
happen to our investment, we must be able to list all the possibilities.
Imagining all the possible payoffs and the likelihood of each one is a
difficult but indispensable part of computing risk.
By listing all possibilities and computing the expected payoff, you get a clearer
picture of the risk involved. This process helps you make informed decisions
about whether the investment is worth taking, given the uncertainty. In this case,
you must decide whether the potential gain is worth the risk of a possible loss.
 Fourth, our definition of risk refers to an investment or group of
investments. We can use the term investment very broadly here to
include everything from the balance in a bank account to shares of a
mutual fund to lottery tickets and real estate.
Risk, as defined in finance, applies to a wide range of investments. The term
"investment" is used broadly and can refer to any financial vehicle where an
individual puts in capital with the expectation of future payoff or return. Each type
of investment carries a different level of risk based on its characteristics and
market conditions. Let’s explore different types of investments and how risk
applies to each:

Types of Investments and Their Risk Levels:

1. Bank Account (Low Risk):

- Investment: The balance in a savings account, fixed deposits, or time
deposits.
- Risk: Extremely low. The risk primarily comes from inflation eroding the
purchasing power of money over time
- Example: If you deposit ₱500,000 in a savings account earning 1% interest,
there’s virtually no risk of losing the principal, but the return is low.

2. Government Bonds (Low to Moderate Risk):

- Investment: Bonds issued by the government (e.g., Retail Treasury Bonds in
the Philippines).
- Risk: Considered low risk because governments are unlikely to default. The
main risk is interest rate risk—if interest rates rise, the bond’s price falls. There’s
also inflation risk, where inflation erodes the real value of the interest payments.
- Example: A 5-year government bond with a 4% annual coupon might lose
value if interest rates rise to 6% after you purchase the bond.
3. Mutual Funds (Moderate Risk):
- Investment: A pool of funds managed by a professional that invests in a
diversified portfolio of stocks, bonds, or a combination of assets.
- Risk: Varies based on the fund’s asset allocation. Equity mutual funds
(investing in stocks) are riskier than bond funds, but diversification reduces risk
compared to investing in individual stocks. Market volatility, economic downturns,
and poor fund management can affect returns.
-Example: An equity mutual fund might give a 10% return in a good year, but
lose 5% in a bad year, depending on market performance.

4. Lottery Tickets (High Risk):

- Investment: Purchasing lottery tickets is technically an investment because
you spend money with the hope of winning a big payoff.
- Risk: Extremely high risk. The probability of winning is incredibly low, and
most lottery participants will lose their money. There’s no predictable return, and
it’s more speculative than traditional investments.
- Example: You buy a ₱50 lottery ticket with the potential to win ₱5 million, but
the odds of winning are 1 in 10 million.

5. Real Estate (Moderate to High Risk):

- Investment: Purchasing property, such as land, homes, or commercial
buildings, with the expectation that their value will increase over time or that they
will generate rental income.
- Risk: Real estate risk comes from fluctuations in the property market, interest
rate changes (which affect mortgage rates), and location-specific risks. For
example, a drop in demand or economic downturns can reduce property values.
There’s also liquidity risk, as selling real estate can take time.
- Example: Buying a condominium in Metro Manila may yield a 30% return over
5 years due to rising property prices, but if the market crashes, you could face
significant losses.
 Fifth, risk must be assessed over some time horizon. Every
investment has a time horizon. We hold some investments for a day
or two and others for many years. In most cases, the risk of holding
 an investment over a short period is smaller than the risk of holding it
over a long one.
In investing, your time horizon is the period you expect to hold an investment
before you need the money.
Time horizons are largely dictated by investment goals and strategies. For
example, saving for a down payment on a house, for maybe two years, would be
considered a short-term time horizon while saving for college would be a
medium-term time horizon, and investing for retirement, a long-term time horizon.
 Finally, risk must be assessed relative to a benchmark rather than in
isolation. If someone tells you that an investment is risky, you should
immediately ask: “Relative to what?” The simplest answer is
“Relative to an investment with no risk at all,” called a risk-free
investment. But there are other possibilities, often more appropriate.
For example, in considering the performance of a particular
investment advisor or money manager, a good benchmark is the
performance of a group of experienced investment advisors or
money managers. If you want to know the risk associated with a
specific investment strategy, the most appropriate benchmark would
be the risk associated with other strategies.
A benchmark is often a market index, or combination of indexes that investors
and portfolio managers use to measure an investment portfolio’s performance.
An index tracks the performance of a broad asset class, such as stocks of
companies listed on stock exchanges.

Sources of Risk: Idiosyncratic and Systematic Risk

Risk is everywhere. It comes in many forms and from almost every imaginable
place. In most circumstances the sources of risk are obvious. For drivers, it’s the
risk of an accident; for farmers, the risk of bad weather; for investors, the risk of
fluctuating stock prices. Regardless of the source, however, we can classify all
risks into one of two groups: (1) those affecting a small number of people but no
one else and (2) those affecting everyone. We’ll call the first of these
idiosyncratic risks , or unique risks, and the second systematic risks , or
economywide risks. 6 To understand the difference between idiosyncratic and
systematic risk, think about the risks facing Ford Motor Company stockholders.
Why should the value of Ford’s stock go up or down? There are two main
reasons. First, there is the risk that Ford will lose sales to other car makers. If
Ford fares poorly compared with its competition, its market share (and thus its
share of all economic activity) may shrink (see Figure 5.4 ). This risk is unique to
Ford, because if Ford does relatively poorly, someone else must be doing
relatively better. Idiosyncratic risk affects specific firms, not everyone. The
second risk Ford’s stockholders face is that the U.S. industry as a whole will do
poorly (see Figure 5.4). This is systematic, economywide risk. If we think of
idiosyncratic risk as a change in the share of the automarket pie, systematic risk
is a change in the size of the pie of the entire economy, of which the auto market
is a part. In other words, systematic risk is the risk that everyone will do poorly at
the same time. The entire economy could slow for reasons that are completely
unrelated to any individual company’s performance. Macroeconomic factors,
such as swings in consumer and business confidence brought on by global
economic conditions or changes in the political climate, are the source of
systematic risks that affect all fi rms and individuals in the entire economy.
Idiosyncratic risks come in two types. In the first, one set of fi rms is affected in
one way and other fi rms in another way. An example would be a change in the
price of oil. History tells us that when oil prices rise, auto sales fall, and the
automobile industry suffers. But higher oil prices improve the profits of fi rms that
supply energy, such as ExxonMobil, Shell, and Texaco. An oil price change that is
bad for Ford is good for the oil companies. Looking at the economy as a whole,
this is an idiosyncratic risk. Not all idiosyncratic risks are balanced by opposing
risks to other fi rms or industries. Some unique risks are specific to one person or
company and no one else. The risk that two people have an automobile accident
is unrelated to whether anyone else has one. We will include these completely
independent risks in the category of idiosyncratic risks.

Reducing Risk through Diversification

When George T. Shaheen left his $4 million-a-year job overseeing 65,000
employees of a large management consulting firm to become chief executive of
the Webvan Group, he may not have realized how much of a risk he was taking.
He thought Webvan would change the way people bought their groceries.
Consumers would order their cereal, milk, apples, and ice cream over the
Internet, and Webvan would deliver to their door. In November 1999, just a few
months after Mr. Shaheen joined the company, his stock in Webvan was worth
more than $280 million. But by April 2001, his shares were worth a paltry
$150,000 and Mr. Shaheen had left the company. On July 10, 2001, Webvan
collapsed and stockholders were left with nothing. What happened to Webvan
and its plan to change the way people shop? Maybe people actually like getting
out of the house and going to the grocery store. But this story is about more than
shopping; it’s also about risk. Shaheen took on so much risk that a single big loss
wiped him out. Traders in the financial markets call this experience “blowing up.”
Surely Shaheen could have done something to protect at least a portion of his
phenomenal wealth from the risk that it would suddenly disappear. But what?
Cervantes answered this question in Don Quixote in 1605: “It is the part of a wise
man to keep himself today for tomorrow, and not to venture all his eggs in one
basket [emphasis added].” In today’s terminology, risk can be reduced through
diversification, the principle of holding more than one risk at a time. Though it
may seem counterintuitive, holding several different investments can reduce the
idiosyncratic risk an investor bears. A combination of risky investments is often
less risky than any one individual investment. There are two ways to diversify
your investments. You can hedge risks or you can spread them among the many
investments. Let’s discuss hedging first.
Hedging Risk
Hedging is the strategy of reducing idiosyncratic risk by making two investments
with opposing risks. When one does poorly, the other does well, and vice versa.
So while the payoff from each investment is volatile, together their payoffs are
stable.

The idea behind allocating your money between different assets is to spread risk
through diversification and to understand these characteristics and their
implications on how a portfolio will perform in different conditions

Diversification is the practice of spreading your investments around so that your

exposure to any one type of asset is limited. This practice is designed to help
reduce the volatility of your portfolio over time.

Speculation: Trading With High Risks, High Potential Rewards

 Speculation refers to the act of conducting a financial transaction that has
substantial risk of losing value but also holds the expectation of a
significant gain
 Without the prospect of substantial gains, there would be little motivation to
engage in speculation.
  Consider whether speculation depends on the nature of the asset,
expected duration of the holding period and/or amount of applied leverage.

At its core, speculation is the act of trading in high-risk assets with the
expectation of substantial returns. Speculators, unlike typical investors, focus on
leveraging market fluctuations for maximum gains rather than sticking to long-
term investment strategies.

 Time Horizon: Before you make any investment, you should always
determine the amount of time you have to keep your money invested. If
you have $20,000 to invest today but need it in one year for a down
payment on a new house, investing the money in higher-risk stocks is not
the best strategy. The riskier an investment is, the greater its volatility or
price fluctuations. So if your time horizon is relatively short, you may be
forced to sell your securities at a significant loss. With a longer time
horizon, investors have more time to recoup any possible losses and are
therefore theoretically more tolerant of higher risks. For example, if that
$20,000 is meant for a lakeside cottage that you are planning to buy in 10
years, you can invest the money into higher-risk stocks. Why? Because
there is more time available to recover any losses and less likelihood of
being forced to sell out of the position too early.

The pyramid, representing the investor's portfolio, has three distinct tiers:2
 The Base of the Pyramid: The foundation of the pyramid represents the
strongest portion, which supports everything above it. This area should
consist of investments that are low in risk and have foreseeable returns. It
is the largest area and comprises the bulk of your assets.
 Middle Portion: This area should be made up of medium-risk investments
that offer a stable return while still allowing for capital appreciation.
Although riskier than the assets creating the base, these investments
should still be relatively safe.
 Summit: Reserved specifically for high-risk investments, this is the
smallest area of the pyramid (portfolio) and should consist of money you
can lose without any serious repercussions. Furthermore, money in the
 summit should be fairly disposable so you don't have to sell prematurely in
instances where there are capital losses.
The pyramid, representing the investor's portfolio, has three distinct tiers:2
 The Base of the Pyramid: The foundation of the pyramid represents the
strongest portion, which supports everything above it. This area should
consist of investments that are low in risk and have foreseeable returns. It
is the largest area and comprises the bulk of your assets.
 Middle Portion: This area should be made up of medium-risk investments
that offer a stable return while still allowing for capital appreciation.
Although riskier than the assets creating the base, these investments
should still be relatively safe.
 Summit: Reserved specifically for high-risk investments, this is the
smallest area of the pyramid (portfolio) and should consist of money you
can lose without any serious repercussions. Furthermore, money in the
summit should be fairly disposable so you don't have to sell prematurely in
instances where there are capital losses.

Why Are Stocks Considered to Be Riskier than Bonds?

On average, stocks have higher price volatility than bonds. This is because
bonds afford certain protections and guarantees that stocks do not. For instance,
creditors have greater bankruptcy protection than equity shareholders. Bonds
also provide steady promises of interest payments and the return of principal
even if the company is not profitable. Stocks, on the other hand, provide no such
guarantees.

Market volatility is the frequency and magnitude of price movements, up or

down. The bigger and more frequent the price swings, the more volatile the
market is said to be.

Market volatility is measured by finding the standard deviation of price changes

over a period of time. The statistical concept of a standard deviation allows you
to see how much something differs from an average value.