Investment risk, a seemingly simple term but within lies an inexhaustible supply of risk factors that need to carefully understood and managed. Here are the generic ones: the international economy, general US economy, regional economy, monetary (US and International), governmental (federal and state), regulatory, industry, company, weather, etc. The level of each of these risks as affecting each investment varies considerably. For instance, a regionally based pharmaceutical distribution company may have little international risk but have a considerable regulatory and industry risk. The market always evaluates these risks and does this in its daily pricing of the individual securities.
What is meant by the term “Investment Risk”? Most unskilled investors think it means risk of total loss but that is very wrong. The overwhelming investment risk is “fluctuation in value”. There are of course contrarian investors, speculators, and hedge funds who look for down fluctuations but the overwhelming majority of investors look for up fluctuations in value and want to discard or sell those investments that are perceived as down fluctuations in value. The markets are made of buyers and sellers. Buyers typically expect up fluctuations in value while sellers typically expect down fluctuations. The result is a market valuation or price that balances the expectations of all the parties to transactions in a particular security.
If this is a 50/50 balancing of expectations, why do more investors look for up fluctuations in value than down fluctuations in value? There probably is no definitive way of knowing but there are a number of reasons why this might be so? Among them is the expectation or desire to accumulate money and property, the desire to go with a winner, the desire to not get stuck with a loser, and perhaps more significantly the historical up returns of all the various types of investments. Some fundamental market metrics of historical returns highlight this. (Source: Andex Chart 2011 Measuring Period: 1926 to 2010)
US Small Stock Total Return Index – 12.1%
S&P 500 Total Return Index – 9.9%
Balanced Portfolio – 8.8%
World Stock Market ex US – 8.2%
Long Term Govt Bonds – 5.5%
5 Yr Fixed Term Investments – 4.8%
30 Day Treasury Bills – 3.6%
Inflation – 3.0%
The whole point of the above data is that it convincingly supports several conclusions. First, the market for all securities always has the inherent risk of value fluctuation. Second, if given enough time, the market historically has always gone up. This is true regardless of the type of security. Third, although not apparent from the above table, the degree and length of value fluctuation in a particular type of security increases with an increased return. Fourth, inflation also increases and fluctuates over the same time period but in lock step with any of the charted market metrics.