Have you ever heard of the game of RISK?
RISK is probably the best known and most played war game. The game of RISK was first released in France in 1957 and made its way to the US in 1959. It is a game of world domination, where the object is to conquer the world. The game board features a map of six continents divided into 42 territories and accommodates two to six players.
The roll of the dice means a lot in the game of RISK. But so do strategy and intelligent tactical decisions. Winning involves a bit more than knowing the rules. the game requires strategic thinking. With each turn, how you will launch daring attacks requires you to make decisions. You also must defend your territory and move across continents with your plan to take over the world. Every decision made is subject to immediate or future risk. The game ends when there is only one player remaining.
Have you ever played it? What kind of player were you? Did you like to start off aggressively and march right into battle? Did you like to form alliances with other players and share risks? Or, did you study the game’s most probable winning strategies to tilt the odds in your favor?
Helping you Understand the Game of Risk
At Henry V. Kaelber, CPA, CFP®, CGMA, we are committed to providing our clients and readers with every advantage when trying to preserve and grow their human, intellectual and financial wealth. We seek to empower you with the results of careful, deliberate and rigorous thinking.
In this article we will provide you an introduction to some basic types of investment risks. And, we will briefly suggest how to factor risk into your decision making and investing strategy. If you are looking for information and ideas to help you achieve better long-term results with your decisions, we think you’ll get a great deal from this article.
Henry V. Kaelber, CPA, CFP®, CGMA is a CPA firm in Charlottesville, Virginia, providing quality accounting & tax services for individuals, business, trusts & estates. We also offer business consulting services and private equity structuring support.
Do You Study the Most Probable Winning Strategies?
What kind of investor are you? Do you ponder risk that you’ll be subject to when you decide whether or not to invest? Do you study the most probable winning strategies to tilt the odds in your favor? If you answered “yes” to the last question, you may be among a successful minority of investor types.
When we invest or don’t invest, it is our turn to roll the dice in the financial game of RISK. Before knowing the eventual outcome, investing requires committing to a decision. Therefore, a specific strategy should guide the decisions we make. A strategy for how we will launching daring attacks and defending against losses. Then, we can earn enough to enjoy the world in our own fashion. Yet, it is hard to formulate a strategy when you don’t fully understand the rules of the game. It is also hard to distinguish a good investment strategy from a bad one without considering the risks.
Investment Risk – Course 101
As investors ponder the possible outcomes of their decisions, behavioral scientists believe that we don’t often think enough about risk. We shall define risk as the possibility of an undesirable result. Sir John Krebs, a former professor at Oxford, stated that “we all take risks. But most of the time we do not notice them. We are generally bad at judging the risks we take. And in the end, for some of us, this will prove fatal.”
If true, maybe this is due to lack of understanding, impatience or the over-whelming emotional effect of considering risk. First, let’s consider some basic premises of how we make decisions.
In Dr. Tom Spradlin’s “Lexicon of Decision-Making”, he explains: “At the time of the decision, the decision maker has available to him at least two alternatives, which are the courses of action that he might take. When he chooses an alternative and commits to it, he has made the decision and then uncertainties come into play. These are those uncontrollable elements that we sometimes call luck.
Different alternatives that the decision maker might choose might subject him to different uncertainties, but in every case the alternatives combine with the uncertainties to produce the outcome…For example, an objective might be to increase wealth, but any alternative intended to lead to that outcome might lead instead to poverty…A bad decision may lead to a good outcome and conversely a good decision may lead to a bad outcome. The quality of a decision must be evaluated on the basis of the decision maker’s alternatives, information, values, and logic at the time the decision was made.”
Achieving Positive Results Should Not Be Left To Luck
In the world of investing, the probability of consistently achieving positive results should not be left to luck. When one gains confidence based upon past luck, your decisions could certainly lead to an outcome of poverty. This occurs when risks are not considered in the equation.
It should also be considered that risk is unavoidable. This seems best articulated in the Wikipedia.org introduction to investment risk. “On ground of assurance of the return, there are two kinds of investments – Risk-less and Risky. “Risk-less” investments are guaranteed, but since the value of a guarantee is only as good as the guarantor, those backed by the full faith and confidence of a large stable government are the only ones considered “risk-less.” Even in that case the risk of devaluation of the currency (inflation) is a form of risk appropriately called “inflation risk.” Therefore no venture can be said to be by definition “risk free” – merely very close to it where the guarantor is a stable government.”
In the investment world, the game is fraught with a great many risks to consider. In fact, there are so many that you may easily be overwhelmed by the number of them. And the pursuit of identifying each and every one prior to making a decision is a daunting task. But that doesn’t mean that they should be ignored. So let’s begin to discuss a framework for understanding them.
It is believed that all risk falls within one of two “buckets”. Either it can be classified as “systematic” risk or “unsystematic” risk. I know that these terms can seem quite technical and I’ll do my best to simplify their meanings for you.
Systematic Risk And UnSystematic Risk
Generally, the word “systematic” is associated with following a logical and methodical series of events. However, I want you to focus more on the word “system”. Systematic risk should be considered as any type of risk that is influenced by broad factors. Think of these types of risks as being influenced by being part of a bigger group. Call it risk by association.
As an example, let’s consider “market risk”. If the stock market suffers a downward correction, you may have seen your particular investments dragged down by the “market”. When we look further into types of market risk, they can be broken down into smaller segments of systematic risk. They could be geographically related, industry related or even, grouped by company size.
Whereas, unsystematic risk is any risk that is unique or specific to a particular situation. These are risks whose outcomes are not particularly related to or shared by a broad group. The two most common sources of these specific types of risk are business risk or financial risk.
Business risk relates to any number of situations where events could occur that would hinder the operations of a company. And, financial risk relates to the possibility that a company will not have adequate cash flow to meet its debt service obligations or its operating expenses.
Now, let’s identify a few types of investment risk and test yourself to see how you would classify them.
Basic Investment Risks
When we begin to identify investment risks, try and think of how a tree forms. The primary stem of the tree forms the tree trunk – let’s call this all risk. Then, offshoots from the trunk will form into the initial broad branches – let’s call these “systematic” risk limbs. Then, each of these broad branches will form smaller limbs that will blossom leaves. Let’s call the smallest limbs and leaves “unsystematic” risk twigs and leaves.
In terms of gauging the impact of risk types in your decision-making, you should begin to understand that as you go further “out on a limb” or higher “up the tree”, the more severe the impact may be should you suffer an adverse or bad outcome.
The above section described Market Risk, Business Risk and Financial Risk. And, listed below are some other basic investment risk types. I’ll leave it to you to determine where they fit on the “risk tree”.
Some Risks That Are Easier To Predict
Liquidity Risk. This risk has to do with how readily you can buy or sell an investment or a personal use asset. It is important to understand that any asset is only as valuable as another person would pay you for it. If you readily need to sell an illiquid asset and nobody wants to trade with you, you may have to liquidate at a much lower price than expected in the market place. Liquidity risk can also compound other risks. This occurs when a company, or a country or a financial market experiences a liquidity crisis.
Credit Risk. This risk is the same as “financial risk” explained above.
Active Risk. This refers to risk attributable to decisions made by the portfolio manager and is exclusive of any market risk. Active portfolio management is simply an attempt to beat the market as measured by a particular benchmark like the S&P500. Active risk has more to do with how well an active manager may or may not perform relative to his or her index benchmark from both a risk (volatility) and return perspective.
Asset Allocation Risk. As opposed to active risk, this risk relates more to the adequacy of, or lack thereof, investment diversification. When a portfolio has any over-concentrated risk , diversification is inadequate. This can happen due to undisciplined risk-taking or through ignorance of over-lapping positions. Asset allocation risk is sometimes unavoidable. When two or more markets, generally driven by dissimilar factors, begin to act similarly, asset allocation risk is unavoidable.
Some Risks That Are Not So Easy To Predict
Inflation Risk. “Purchasing Power Risk” is a similar description of this risk type. Inflation risk impacts investors in many ways. Through the ages, the cost of purchasing goods and services has risen over time. You lose purchasing power over time if you keep your money under a mattress. You also lose purchasing power when your investments don’t keep pace with inflation . And, inflation also impacts market risk, interest rate risk, political risk, currency risk, etc.
Interest Rate Risk. This is the risk that the relative value of a loan made between a borrower and a lender will worsen. This is the risk of a change in the market interest rate for loans. Changes in market interest rates impacts government bonds, corporate bonds and loans between a banker and an individual. A government’s monetary policy, inflation risk or other factors all impact he market for interest rates.
Currency Risk. Also known as “foreign exchange risk”, this is a type of “market risk”. Currency risk can adversely impact the purchasing power of goods, services and investment between parties in one country trading with parties in another country. For investors, it can reverse or enhance returns earned on investments; and, for consumers, it can adversely impact the cost of purchases. A weaker currency can make imported goods and services more costly. And, at the same time, make exporting goods and services more attractive.
Political Risk. Political risk is also “legal risk” or “regulatory risk”. When a government, or agency, changes its political structure or policies, the impact can trigger many other risks. Certainly every one of those risks described above.
What Kind of Investor Are You?
When we started this article, we discussed the board game called RISK. We also discussed how winning at that game required more than just knowing the rules. In that game, strategic thinking is a requirement. And every decision made is subject to immediate and future risk. The same is true for investing.
As stated earlier in this article, luck is never a good strategy for consistently achieving positive results. When one gains confidence based upon past luck, your decisions made could certainly lead to an outcome of poverty. When the decision does not consider risks in the equation, the probability of loss is higher. As with game of RISK, where the roll of the dice means a lot, luck plays a role in the investment process. Yet, it is strategic thinking and intelligent decisions that help you win at both the game and when investing.