LEVEL: INTERMEDIATE
As a potential future investment manager, you must understand that your primary goal should be to evaluate and assess risk properly. As you start to look more into the industry and read financial publications, you will often see the word risk, but it is actually very difficult to really define it as one precise element at all. It can take various forms and can often do so very unexpectedly. The different types of risk that are typically the most relevant to equity investing are systemic, fundamental, technical, and “analyst”. Let’s look at some examples for each.
Systematic Risk
Systemic risk is a term that has become a catch phrase by politicians following the financial crisis of 2008. Systemic risk is proclaimed to be unavoidable and typically can result from an overall economic slowdown that can be primarily blamed on the effects of the business cycle. In periods often following a large expansion period or once a “peak” has been reached, the economy will start to contract (often signaled by a major change in the yield curve) and companies will have trouble growing in this environment. Systemic risk can also be event driven and can include political decisions, natural disasters, or anything that can cause the overall economy to come to a halt.
Fundamental Risk
Probably the most basic type of risk for an investment manager is the inherent fundamental risk in holding individual equities. Companies will all face external risks whether they are on the demand or supply side. The primary method to reduce fundamental risk is diversification within a portfolio. This can essentially be done in two ways and here will be provided an example. If you have a view that the demand for oil is going to rise across the next 4 months, then your thesis would suggest buying oil producers like Exxon and BP. Choosing one alone will expose you to company specific problems, say the CEO resigns, accounting scandal, lost contract, etc. In the event that this happens, you may not fully benefit from increased oil prices. Picking several or more oil companies may reduce your overall returns, because as they are competitors, one may benefit more than the other. But what if your prediction on increased oil demand is not fulfilled at all? Then these stocks more than likely will under-perform, and your portfolio will suffer. This is where it is very critical to be invested in other equities (technology, healthcare, infrastructure, etc.) as their performance is less correlated to the equities you have chosen. If you diversify properly, you can significantly reduce the risk in your portfolio. This is a practice that is refined by the best investment managers.
Technical Risk
Markets are filled with more participants as every day passes. And everyone in the market has at least two things: a unique buying power and a unique objective. These two aspects often combine to form how an investor will allocate capital and are heavily influenced by where the specific stock has been trading so far. This is the technical risk component and helps understand why a stock is trading in a certain way despite the underlying fundamentals of the business. Some examples may make this clearer.
If the market experiences some short-term bad economic news such as a low PMI (purchasing manager index) number, traders will often put large selling pressure on the broad market as a major strategy. For longer term managers, this is a buying opportunity as they can start to purchase shares on weakness. The latter of these has a much larger buying power, but because of that same power they must not become too aggressive or they will find that they are the only buyer.
Technical risk is about timing; in order to have any successful investment you must buy before someone else. This can often be forgotten. Determining the best time to go long when there are short-term buyers and long-term buyers accumulating stock will lead to the least risk as long as you pay attention to the opposite periods when selling pressure increases. The issue of technical risk is a very in depth subject, but one you should definitely begin to understand as you compile a portfolio.
Analyst Risk
Lastly, and sometimes the most intimidating, is the risk that goes along with analyst predictions. Wall Street has been placing estimates on company performance since its inception. Whether that is for better or worse is a discussion for another time, however it has been accepted as a foundation of equity markets. Analysts from a multitude of investment banks pour over financial statements and construct financial models to project what a firm should earn, sell, and a variety of other metrics they find valuable. They often publish these ahead of when the company is expected to release – you can find most estimates available on financial information sites like Yahoo Finance and Google Finance. The more in depth reports on the other hand will be typically kept private amongst the banks’ clientele. After the earnings number and guidance is released, the analysts will typically readjust their projections, and the market will react to the number. It is commonly believed that analysts, in the interest of self-preservation, often underestimate projections since no one likes to “not meet expectations” or likes a stock to sell off. This is something to consider along with the fact that no one analyst typically wants to differ from the herd of other analysts. Studying the reactions to earnings and how particular companies and/or industries respond will help you start and understand the risk more completely.
These are some of the many risks you will face as a potential investment manager and this only scratches the surface of the topic. I heard a saying once by a manager – I only worry about the downside, the upside takes care of itself. If you adapt a similar approach your odds of success will be much higher.