Overview – Getting to Know Investment Risk
One of the most, if not the most, foundational concepts in investing is the relationship between risk and return. For investors to receive a return on their capital, they must accept the possibility of potentially losing some, or even all, of it.
No doubt almost every investor has heard of “investment risk” at least once in their careers. While this term is brought up regularly in investment discourse, this leads to a simple, yet critical question: what exactly is “investment risk”?
In this article, we will define investment risk, how it differs from volatility, and learn how to use a very simple yet powerful engineering safety tool known as the risk matrix to help assess investment risk.
Is Volatility Just Another Term for Investment Risk?
Many times, when investors talk about the risk of a given investment, they point to its historical price fluctuations to support their argument. For example, whenever a given stock shows a history of very wide price swings within a short period, many investors are quick to label it as “risky”.
On that same token, many investors are quick to call an investment “safe” if they see that it has a track record of price stability.
So, is investment risk simply a matter of how volatile a given investment is? Not at all. If it were, then picking “safe” investments would only involve finding out which ones exhibit the least volatility, but as we’ll discuss later it isn’t that simple.
It doesn’t help that certain metrics, such as Beta, are touted as ways to quantify risk when in reality all they do is quantify volatility. This isn’t to say that volatility and its related metrics are useless: there are certainly investors and other stakeholders who care a lot about how prices change, especially if they plan on selling at a specific time for the express purpose of securing capital gains.
However, a volatile investment can be relatively safe, while one that exhibits minimal price swings can be on the verge of collapse. How is that possible? By understanding what investment risk entails.
Defining Investment Risk
Say you go to a beach resort, and you learn that there have been shark sightings in recent days. Although shark attacks have happened before, they only ever show up late at night or in the early hours of the day, well outside typical beach hours. In addition, they usually avoid the beaches that tourists frequent during the day. So, sharks present a serious hazard, yet the likelihood of being a victim of an attack, let alone running into one, is very low.
Back home, you live just a few kilometres away from a chemical plant. The smoke that’s discharged from it contains trace amounts of carcinogens. Although there’s some distance between you and the chemical plant, some of these trace carcinogens make it to your home, which you regularly inhale. This chronic exposure to trace amounts of carcinogens can increase your risk of getting cancer.
Risk is comprised of two factors: a hazard that has the potential to bring harm, and the probability of that hazard materializing and inflicting said harm. This can be expressed as:
Risk = Severity of Hazard * Likelihood of Hazard materializing
This definition of risk is the one that’s commonly used in the domain of engineering safety and risk management. However, it can be applied to many different scenarios beyond engineering problems.
In our first example, the risk of being involved in a shark attack can be classified as “low” because although the hazard is very severe, the likelihood of encountering a shark is very minimal. Conversely, the risk of getting cancer in our second example can be labelled as “moderate” or “moderate-high” because of the continuous exposure to carcinogens that can accumulate over time.
When applying this definition to investing, we can make some adjustments to fit our purposes.
Investment risk, just like any other risk, is comprised of a hazard and likelihood. In this case, a “hazard” is something that could potentially impact investment merit and subsequently result in an investor losing their capital. Likelihood, just like before, is the chance of that hazard materializing.
This is why volatility isn’t an indicator of risk: it only looks at how price changes, but doesn’t take into account the underlying business fundamentals. During times of market upheaval, it’s not unheard of for most investment instruments to experience major price swings, but for the underlying business fundamentals to remain largely intact. When the tide recedes, every boat is lowered.
It’s also possible for an investment to exhibit minimal price changes but is currently dealing with declining business health which simply isn’t being reflected in its price.
So, we now know what investment risk is and how it applies to investing, but how exactly are specific risk ratings assigned? One method is to use something known as a “risk matrix”.
The Risk Matrix
With a clear definition of risk now in mind, the next task is to understand the extent of the risk being dealt with. Given the wide range of hazard severity and the likelihood of them materializing, how can we distinguish between different risk severities?
A simple, yet effective tool we can use is the risk matrix, shown below.
This particular matrix, the fundamental variant, is by far its simplest form but can serve as an excellent starting point for more detailed risk assessment.
Notice that the fundamental risk matrix is a qualitative tool. Therefore risk, at best, can only ever be approximated when using this tool. Because of that, it’s very difficult to distinguish the subtleties between similar yet distinct risks.
Due to this inherent shortcoming, what qualifies as a low, moderate, or high risk is not always easy to differentiate, and some risk levels may overlap. A simple solution to this is to make a more detailed risk matrix and outline specific conditions on where to place hazards and likelihoods:
A risk matrix can be as simple or complex as an investor needs it to be and can be adjusted to the specific investment instruments they’ll be assessing.
Naturally, there are more sophisticated tools that can quantify risk, and again, are commonly used in the domain of engineering safety. However, a detailed discussion of these tools is beyond the scope of this article, not to mention the increased difficulty of adapting those tools for investment purposes.
That being said, most investors don’t need highly detailed risk assessments, and the approximations given by a risk matrix are usually enough to help investors gain an understanding of the risks they potentially face while still allowing them to make informed and effective decisions.
Using the Risk Matrix – A Simple Example
Knowing about the risk matrix is a good start, but risk insights can only be gained from it when it is properly used. Fortunately, the risk matrix isn’t an overly complicated tool.
That being said, there may be times when investors may need to make a judgment call when deciding where to place certain hazards and likelihoods, and these judgments will rely on an investor’s experience, knowledge, and intuition.
Let’s see how we can use the risk matrix in practice, using the Royal Bank of Canada (RBC) as the company we’ll be studying.
Using the Risk Matrix: Royal Bank of Canada
The Royal Bank of Canada (RBC) is one of the largest financial institutions in Canada, and although it has “bank” in its name, they offer a wide variety of financial services.
Just like its peers, RBC’s revenue can be divided into two major groups: interest and non-interest income. Despite their variety of services, gross interest income almost always is the larger contributor to overall revenue.
Upon closer inspection of their income statement, it’s clear that the bulk of that interest income comes from the loans that RBC extends to its clients which, like its peers, is common to see. Although they are a source of RBC’s financial strength, the loans they extend are also a potential hazard.
Should a sizeable portion of these loans end up becoming impaired, then RBC can take quite a significant hit to their revenue. This isn’t entirely hypothetical: starting in 2022 and even throughout 2023, major Canadian banks increased their provision for credit losses (PCLs) in anticipation of higher borrowing costs and weaker economic conditions.
Assuming a flurry of loans does become impaired, then RBC could face a significant decline in revenue, hampering their ability to repay creditors, pay dividends, and pursue growth projects. For investors, this could translate into a gradual, yet consistent, decline in share price, evaporating their capital in the process. Therefore this hazard can likely be classified as “moderate” or “moderate-high” in terms of impact.
Given RBC’s diverse loan portfolio in terms of the quality of their borrowers, the types of loans they offer, and the geographic locations of these borrowers, the likelihood of mass loan impairment across the board is arguably low.
So, with this information in mind, we can now turn to the risk matrix and determine the investment risk posed by RBC’s loan portfolio. Upon doing so, we can make the case that risk can be classified somewhere between “low” or “low-moderate”; this will vary based on individual judgment and risk tolerance.
Investment Risk Is the Sum of Many Individual Parts
After finishing our example with RBC, we concluded that the investment risk posed by their loans can be classified as “low” or “low-moderate”. Does that mean we can extend that same classification to the entire organization?
Although the risk posed by that specific element is low doesn’t mean the same can be said for all the others. RBC’s brokerage services, insurance, wealth management, and wholesale banking all have the potential to weigh them down.
It’s entirely possible for RBC, or any business for that matter, to exhibit low risk in some areas of operation while dealing with high risk in others.
So, what does this mean for investors?
To get a better understanding of the overall investment risk posed by a business or any other investment instrument, they must assess risk across multiple areas. By understanding the risks posed by individual parts, a holistic understanding of overall investment risk can be better achieved.
The use of multiple tools also helps create a clearer picture of those different risks. In addition to the risk matrix, other risk-assessment methodologies such as performing ratio analysis and understanding some qualitative factors can help piece together a more thorough risk assessment.
Naturally, this begs the question of how many individual components must be assessed. Unfortunately, there is no straightforward answer to this: different types of investments will have varying numbers of individual parts to look at, and it’s possible that not every individual component needs to be looked at to get a satisfactory overall risk picture.
What matters is that investors don’t get too hung up on one element of an investment and that they assess as many individual components they feel are necessary to get a holistic understanding of overall investment risk.
Controllable vs Uncontrollable Risks
One of the frustrations that come when dealing with investment risk is that not all the factors that contribute to it can be controlled. On top of that, different investment instruments will have different risk factors that are controllable and those that aren’t.
RBC, and other large financial institutions for that matter, face many hazards that are beyond their control but can impact their operations: economic conditions, policy decisions, interest rate changes, and customer behaviour, to name a few. These hazards all have a realistic chance of materializing, potentially hampering a financial institution’s performance, and by extension potentially putting investor capital at stake.
So, why is this important to know? Investors must learn to accept that even if they play all their cards right, there’s still a possibility of losing money because of things they cannot possibly hope to control. As frustrating as this sounds, there is unfortunately still an element of luck when it comes to dealing with investment risk.
Now, this doesn’t mean investors are completely dependent on the whims of luck, nor is this meant to discourage. Proper risk management can help keep risks under control and can minimize the effects of non-controllable factors. This is just a reminder of the reality investors face which is not everything can be controlled, investment risk being one of them.
Investment Risk Can Never Be Fully Eliminated
After assessing investment risk, one of the first things that will come to mind for most investors is “How can I reduce the risk this imposes on my portfolio?” Reducing risk and keeping it low is another topic entirely, which is talked about more in-depth in the Risk Management article.
Unfortunately, investors must learn to accept that investment risk can never be truly eliminated. Although it can be greatly reduced and brought under control, some element of risk will always be present.
This is crucial to understand and accept before investors waste precious time and resources trying to achieve an impossible goal. No investor wants to lose their money, and will understandably do everything they can to prevent that from happening. However, the possibility of losing money will always linger no matter what an investor does.
A skilled investor isn’t somebody who knows how to completely get rid of risk. Rather, they learn to live with it and how to prevent it from becoming a major threat.
This isn’t meant to scare away investors, but rather it serves as yet another reality check to keep expectations at bay. In investing, just like many things in life, you cannot expect to get something for nothing.
Wrapping Up
Many investors talk about investment risk regularly, yet this seemingly basic concept continues to be misunderstood by many.
Investment risk is comprised of a hazard that can potentially impact investment merit, as well as the likelihood of that hazard materializing. Many investors mistakenly conflate volatility and investment risk, yet volatility only looks at price changes, not underlying business fundamentals.
A simple, yet effective tool to assess investment risk is the risk matrix, which can be as simple or detailed as an investor needs it to be.
Although investment risk is relatively simple to assess, there are some factors that contribute to it but are well beyond an investor’s control. Additionally, investment risk can be reduced, but can never be eliminated entirely.
Investment risk will, unfortunately, always be present, but as the saying goes, you cannot hope to get something for nothing.
