As an investor, you deal with risk. Risk represents the chance or possibility something bad will happen that will negatively affect your investment.
Although risk can never be eliminated, investors prefer to minimize it when possible.
At the very least, they want to understand the risk they’re taking when they buy, hold or sell specific securities.
Here are three types of risks you face as an investor and what you should know about them.
Business risk is simply the possibility that the company will lose money.
This is the type of risk that you probably look at the most. What if the company has a bad quarter? What if a drug trial doesn’t go as expected and the company is forced to slash forward guidance? That could mean a significant drop in price.
Business risk can be calculated two ways – one simple, the other complex.
The simple system involves looking at four different ratios or effects. They are contribution margin ratio, operating leverage ratio, financial leverage effect and total leverage effect.
The contribution margin ratio indicates the percentage of sales income left after subtracting variable costs.
For example: If sales revenues were $100,000 and variable costs for those sales were $50,000, the contribution margin ratio would be 50 percent. ($100,000 - $50,000/$100,000.)
Operating leverage ratio represents the ratio of fixed costs to variable costs. As operating leverage increases, increased sales result in higher profits.
On the other hand, high operating leverage hurts the company when sales slow down.
Financial leverage effect is the ratio of operating income to net income. Companies that use debt to finance operations create leverage and represent additional risk if revenues decline or vary.
Finally, there is total leverage effect defined as operating leverage times financial leverage and represents the degree to which net income increases with increased sales.
The complex system for calculating business risk involves statistical analysis.
This system involves analyzing variations in sales and operating income over time (several years) and is typically done by experienced professionals.
Inflationary risk is the risk that your investment will be negatively impacted by inflation.
Since savings accounts don’t pay interest above the rate of inflation, you can actually lose money by keeping it in the bank over time. The same holds true with investments. If the investment doesn’t earn more than the rate of inflation in a given year, you have lost money.
Two terms come into play when considering inflationary risk – nominal return and real return.
The nominal return on your investment is the return without considering inflation.
The real return, as you might expect, involves growth of your investment after inflation has been factored in.
Finally, liquidity risk refers to the risk that comes from owning an investment that cannot be bought or sold quickly enough to prevent loss.
Liquidity risk is often associated with small-cap stocks but sometimes even major, blue chip stocks can be affected.
Such was the case in 2008 when widespread global panic created market illiquidity.
One well-publicized example of liquidity risk – in this case personal liquidity – arose when people who owned homes saw values drop and couldn’t sell them quickly enough to satisfy the balance on their mortgages.
Every investment comes with risk. Investors learn to minimize risks but always know that risk cannot be eliminated completely. A diversified portfolio along with hedging strategies help to offset risk factors.