Stock market volatility has almost become a constant in today’s world and this looks set to continue for some time yet given the various issues faced by the global economy. This raises the issue of risk.
How much risk should be taken? What sorts of risk do investors face? Too many to mention here, but I will remind you of a few of the major ones.
Firstly, credit risk. In the case of bonds it is the possibility that the issuer may not be able to meet interest or principal payments when they become due. Higher-quality bonds issued by companies with strong financial positions usually pose less credit risk than those issued by companies on less solid footing. Investors should check whether bonds are investment grade (rated BBB and above) or High Yield (BB and below) in evaluating possible returns on their investments. For equities, credit risk is the possibility that the company may cut or suspend dividend payments.
Secondly market risk. This risk arises from the possibility that whole markets can decline. An investor may buy a share where earnings and the general financial position are good, only to have its market price drop because overall market sentiment has turned negative.
Business or Event Risk is a case of unforeseen circumstances which may adversely affect the value of investments. It could be either company-specific or industry wide. For example, a firm’s profits may be hurt by a lawsuit, a change in management, or a product failure. Or new government regulations may cause the price of equities in a particular industry (e.g. pharmaceuticals) to drop.
Interest rate risk. Changing interest rates can have a major effect on fixed interest investments. Bond prices typically fall when interest rates rise and increase as rates decline. Rising interest rates depress the value of existing bonds because investors can buy new bonds paying higher prevailing yields – or sit in cash. On the other hand, if rates fall, potential buyers will be willing to pay a premium for an older, higher-yielding bond. Rising interest rates can also make shares less attractive, although any correlation between interest rate changes and equities is less clear. The current low interest rate environment looks to be with us for the foreseeable future in most commentator’s opinion.