Because of the uncertainty that surrounds investments, people often follow a conservative course in an effort to keep their risk low. Being too conservative when investing means that they also risk not reaching their financial goals. To be a successful investor, you must understand the major factors that affect the rate of return on investments. Being informed, you can then take the appropriate risks when making investment decisions.
Random and Market Risk
Random risk (also called unsystematic risk) is the risk associated with owning only one investment of a particular type (such as stock in one company) that, by chance, may do very poorly in the future because of uncontrollable or random factors, such as labor unrest, lawsuits, and product recalls. If you invest in only one stock, its value might rise or fall. If you invest in two or three stocks, the odds are lessened that all of their prices will fall. Such diversification the process of reducing risk by spreading investment money among several investment opportunities provides one effective method of managing random risk. It results in a potential rate of return on all of the investments that is lower than the potential return on a single alternative, but the return is more predictable and the risk of loss is lower. Diversification averages out the high and low returns. Research suggests that you can cut random risk in half by diversifying into as fewas five stocks or bonds; you can eliminate random risk by holding 15 or more stocks or bonds. Rational investors diversify so as to reduce random risk.
Diversification among stocks or bonds cannot eliminate all risks. Some risk would exist even if you owned all of the stocks in a market because stock (and bond) prices in general move up and down over time. This movement results in market risk (also known as systematic or undiversifiable risk). In this case, the value of an investment may drop due to influences and events that affect all similar investments. Examples include a change in economic, social, political, or general market conditions; fluctuations in investor preferences; or other broad market-moving factors, such as a recession or a terrorist attack.
Market risk is the risk that remains after an investor’s portfolio has been fully diversified within a particular market, such as stocks. Over the years, market risk has averaged about 8 percent. As a consequence of this risk, the return on any single securities investment (such as a stock), through no fault of its own, might vary up and down about 8 percent annually. The total risk in an investment consists of the sum of the random risk and the market risk.
Other Types of Investment Risks
A number of other investment risks affect investor returns:
Random and Market Risk
Random risk (also called unsystematic risk) is the risk associated with owning only one investment of a particular type (such as stock in one company) that, by chance, may do very poorly in the future because of uncontrollable or random factors, such as labor unrest, lawsuits, and product recalls. If you invest in only one stock, its value might rise or fall. If you invest in two or three stocks, the odds are lessened that all of their prices will fall. Such diversification the process of reducing risk by spreading investment money among several investment opportunities provides one effective method of managing random risk. It results in a potential rate of return on all of the investments that is lower than the potential return on a single alternative, but the return is more predictable and the risk of loss is lower. Diversification averages out the high and low returns. Research suggests that you can cut random risk in half by diversifying into as fewas five stocks or bonds; you can eliminate random risk by holding 15 or more stocks or bonds. Rational investors diversify so as to reduce random risk.
Diversification among stocks or bonds cannot eliminate all risks. Some risk would exist even if you owned all of the stocks in a market because stock (and bond) prices in general move up and down over time. This movement results in market risk (also known as systematic or undiversifiable risk). In this case, the value of an investment may drop due to influences and events that affect all similar investments. Examples include a change in economic, social, political, or general market conditions; fluctuations in investor preferences; or other broad market-moving factors, such as a recession or a terrorist attack.
Market risk is the risk that remains after an investor’s portfolio has been fully diversified within a particular market, such as stocks. Over the years, market risk has averaged about 8 percent. As a consequence of this risk, the return on any single securities investment (such as a stock), through no fault of its own, might vary up and down about 8 percent annually. The total risk in an investment consists of the sum of the random risk and the market risk.
Other Types of Investment Risks
A number of other investment risks affect investor returns:
- Business failure risk. Business failure risk, also called financial risk, is the possibility that the investment will fail, perhaps go bankrupt, and result in a massive or total loss of one’s invested funds. Investigate thoroughly before investing
- Inflation risk. Inflation risk may be the most important concern for the long-term investor. Inflation risk, also called purchasing power risk, is the danger that your money will not grow as fast as inflation and therefore not be worth as much in the future as it is today. Over the long term, inflation in the United States has averaged 3.1 percent annually. Thus, the cumulative effects of inflation diminish your investment return. Historically, common stocks and real estate have reduced inflation risk, as values tend to rise with inflation over several years. However, houses, real estate, and other ownership investments are also subject to deflation risk. This is the chance that the value of an investment will decline when overall prices decline
- Time risk. The role of time affects all investments. The sooner your invested money is supposed to be returned to you—the time horizon of an investment—the less the likelihoodthat something could go wrong. The more time your money is invested, the more it is at risk. For taking longer-term risks, investors expect and normally receive higher returns
- Market-volatility risk. All investments are subject to occasional sharp changes in price as a result of events affecting a particular company or the overall market for similar investments. For example, the value of a single stock, such as that of a technology company like Microsoft, might change 10 or even 30 percent in a single day. Also, all technology stocks could decline 2 or perhaps 5 percent if two or three competitors announce poor earnings. In an average year, the price of a typical stock fluctuates up and down by about 50 percent; thus, the price of a stockselling for $30 per share in January might range from $15 to $45 before the end of the following December. Liquidity risk. Liquidity is the speed and ease with which an asset can be converted to cash. You can convert your savings into cash instantly. You can sell your stocks and bonds in one day, although it may take four days to have the proceeds available in cash. Real estate is illiquid because it may take weeks, months, or years to sell.
- Reinvestment risk. Reinvestment risk is the risk that the return on a future investment will not be the same as the return earned by the original investment.
- Marketability risk. When you have to sell a certain asset quickly, it may not sell at or near the market price. This possibility is referred to as marketability risk. Selling real estate in a hurry, for example, may require the seller to substantially reduce the price in order to sell to a willing buyer.
Transaction Costs Reduce Returns
Buying and selling investments may result in a number of transaction costs. Examples include “fix-up costs” when preparing a home for sale, appraisals for collectibles, and storage costs for precious metals. Commissions are usually the largest transaction cost in investments. These are fees or percentages of the units or selling price paid to salespeople, agents, and companies for their services that is, to buy or sell an investment. The commission charged to buy an investment (one commission) and then later sell it (a second commission) is partially based on the value of the transaction. Typical ranges for commissions are as follows: stocks, 1.5 to 2.5 percent (although trades can be made on the Internet for less than $20); bonds, 0 to 2.0 percent; mutual funds, 0 to 8.5 percent; real estate, 4.5 to 7.5 percent; options and futures contracts, 4.0 to 6.0 percent; limited partnerships, 10.0 to 15.0 percent; and collectibles, 15.0 to 30.0 percent. You can increase your investment returns by holding down transaction costs.
Leverage May Increase Returns
Another factor that can affect return on investment is leverage. In the leveraging process, borrowed funds are used to make an investment with the goal of earning rate of return in excess of the after-tax costs of borrowing. Investing in real estate for its rental income provides an illustration of leverage, as shown in Table 13.2 Assume.
that a person can buy a small office building either by making a $30,000 down payment and borrowing $270,000 or by paying $300,000 cash. If the rental income is $30,000 annually ($2500 per month) and the person pays income taxes at a 25 percent rate, a higher return can be obtained using credit to buy the building because the yield would be 31.38 percent versus a 7.5 percent yield when paying cash.
Leverage can prove particularly beneficial when substantial capital gains occur, as this strategy sharply boosts the return on the investment. Assume that at the end of one year, the value of the building described in the previous example has appreciated 7 percent and you could sell it for $321,000 (excluding commission costs). If you had purchased the property for $300,000 cash and then sold it for $321,000, the capital gain on the sale would be 7 percent (the $21,000 return divided by the $300,000 originally invested). If you had bought it using credit, the capital gain would be 70 percent (the $21,000 return divided by the $30,000 originally invested, ignoring transaction costs, taxes, and inflation).
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