Asset Class Risk

Every asset class (cash, bonds, stocks, etc.) has risk, either embedded or external. Embedded risks can be associated with specific types of asset classes (e.g. prepayment risk associated with bonds) that may not necessarily pertain to other asset classes. External risks are risks that are often experienced by all asset classes one way or another.

External Risks

Think of external risks as those that can impact any asset class, albeit in different ways. Some external risks include inflation, economic risk, headline risk, domestic/international political risk, industry risk and business risk. For example, in a high inflation, slowing economic environment, with doomsday news headlines, political pressures from legislators focused on a global health care crisis will probably negatively impact the broad stock, bond, commodity and currency asset classes one way or another.

Cash has risk as it may not keep up with inflation. A dollar bill has risk as you could lose it or destroy it in the wash. Stocks have risk as the stock price can go up and down on a second by second basis or the company goes out of business. Let’s address the different types of embedded risks associated with the major types of asset classes.

Types of Asset Class Risks

Investors can group asset class risks into two broad categories: price volatility risk and liquidity risk. Within price volatility and liquidity risks, there are different levels of risk. Within each asset class, there are unique risks as well, which we will go into.

• Price Volatility Risk: the magnitude of the price of the investment over any time period. Price volatility risk is an aggregate of all of the embedded and external risks associated with an investment.
• Liquidity Risk: the length of time to sell your investment and the cost of doing so. Liquidity risk is often forgotten by most investors and is impactful when thinking about investing in general, so I’m calling this out separately. The spread between the bid (the amount you can sell the investment for) and the ask (the amount you can buy the investment for) when trading investments is often an indicator of liquidity. The wider the bid-ask spread, the less liquid the investment and the higher effective cost to trade. For example, if you hold an investment with a limited number of buyers and sellers that shows a $10 price on your trading screen (middle point between bid and ask price), but the bid price (amount you can sell it for) is $9.50 and the ask price is $10.50 (the amount investors want to sell it for), if you sell the investment and receive $9.50, you had a cost of $0.50 per share to sell it, or 5% of the $10 middle point value. Conversely, if the $10 price was an investment in a stock that had millions of buyers and sellers, and the bid price was $9.99 and the ask price was $10.01, and you sell it at $9.99, you only had a cost of $0.01 per share to sell it, or a 0.1% cost. As you can see, the more buyers and sellers, the higher the liquidity, the lower the cost of trading and the lower the liquidity risk.
• Valuation Risk: the risk when an asset class’s valuation rises above its long-term historical average, higher than other asset classes with the same return expectations, and higher than what fundamentals should suggest is an appropriate valuation

Cash and Cash Equivalents

Cash is typically considered the lowest volatility asset class of the major classes. Visible price fluctuations of your cash (we will assume denominated in U.S. dollars), do not happen on a day to day basis. Liquidity risk is also low as you can get access to your cash in your checking and savings account relatively quickly (at the bank, an ATM, pay for something online, etc.). If you have hard dollar bills, you have instant access.

• Price Volatility Risk: Very Low
• Liquidity Risk: Very Low

Cash equivalents are cash-like securities that often pay higher interest than cash have limited (if any) price volatility but may have some increased liquidity risk. To compensate for the added risks, cash equivalents often pay higher interest than cash. Money market funds and short-term Certificates of Deposit (CDs) with maturities of less than 3 months are often considered cash equivalents.

Bonds

Bonds are different than cash and cash equivalents in that they have higher price volatility risk and higher liquidity risk than cash. In addition, there are other associated risks that are tied closely to driving higher price volatility of bonds. These risks include interest rate risk, credit risk and prepayment risk.

• Price Volatility Risk: The price volatility of a bond is driven by all of the embedded risks of the bond. We list some of the biggest embedded risks below.
• Liquidity Risk: Every bond has liquidity risk. Most bonds do not easily trade on a financial exchange like stocks do. For this reason, it can take longer to buy/sell a particular bond at any given point, and it may cost more in transaction costs to do so. Different bonds have different liquidity risks, so it is important for investors to have a good handle on the liquidity risk of a particular bond before they buy or sell that bond.
• Interest Rate Risk: The price movement of a bond when interest rates move higher or lower. The term duration is often used as a metric to define a bond’s interest rate risk. All else equal, when interest rates move higher, bond prices move lower, and vice versa. Often, the longer the time it takes to pay off a bond, the higher the interest rate risk. Interest rate risk (duration) is often tied to the maturity risk of the bond.
• Credit Risk: The ability of the bond issuer to pay interest according to the bond agreement. A U.S. Treasury bond is backed by the U.S. government’s ability and willingness to pay the interest and principal back on the bond. A U.S. Treasury bond is thought to have low credit risk. A small company looking to fund a speculative project by issuing bonds is backed by that company. Since the small company and its project is risky, the bond associated with the funding for the company would be considered to have high credit risk.
• Maturity Risk: The longer the bond is held until the bond agreement is fully paid out is considered maturity risk. A 3 month Treasury Bill has low maturity risk as the probability that it will be paid off in three months is high. A 30-year Treasury bond has a longer time period to be paid back and anything can happen in 30 years. This indicates that the 30-year Treasury has higher maturity risk than a 3-month Treasury bill.
• Prepayment/Callable Risk: The ability of the bond issuer to pay back its principal early, and not allowing the investor in the bond to receive all of the anticipated future interest payments. This phenomenon is also known as callable risk, when a bond issuer can call the bond back from you to refinance at lower interest rates. If you bought a 30-year Treasury from the U.S. government that was paying you an 8% interest rate yield, you would be very happy if interest rates were currently much lower and you still had 25 years left holding that U.S. Treasury bond. If the U.S. government refinanced that bond and instead could buy the bond back from you and offer you a 2% 30-year Treasury bond, you would be less happy. That’s prepayment risk or considered callable risk. Homeowners take advantage of prepayment risk with mortgage refinancing. If you are a homeowner with a mortgage with a 5% interest rate, the mortgage lender hopes to get 5% from you each year on your remaining mortgage. If interest rates move lower and you refinance (pay off original loan, restart a new loan) at a 3% interest rate, the mortgage lender now is only anticipating 3% interest from you each year, losing out on a difference of 2%. if you are an investor, you hope you can lock in higher interest rates on your bonds for long periods of time, rather than receiving less when interest rates fall. In general, as interest rates decline, prepayment risk increases, and vice versa. if you lock in a 3% rate mortgage, and rates move up to 6%, you probably will not want to refinance at a higher rate, so the prepayment risk is lower for the lender.

The global bond market is larger than the global equity market and there are many different types of bonds and bond agreements out there, which means there are many different levels of risks for each specific bond issued. We have dedicated lessons on Fixed Income (bonds) that dig a bit deeper.

Stocks

• Price Volatility Risk: stocks often have the highest price volatility risk due to the significant liquidity across financial market exchanges, and the ability of many types of investors to buy/sell a stock in microseconds. Sometimes higher/better liquidity means higher/worse price volatility. If there is low liquidity, prices can’t move around that much that often by definition
• Liquidity Risk: stock market exchanges and technology has made it easy for millions of investors to trade with each other. For the average investor, liquidity risk isn’t often an issue, particularly when investing in large cap U.S. companies. The bid-ask spread will be relatively tight (pennies) to execute the trade and it could happen instantly with a market order. If you get to very small companies that do not have a lot of trading volume, liquidity can be higher. More often than not, the bid/ask spread will be wider for these companies, which is an embedded cost to trade these low liquidity companies.
• Perception Risk: this is never really an identified risk by most, but it is a risk in realty and can quickly impact a stock’s price over the short-term. With a 24-hour news cycle and news/comments/tweets/etc. being sent around the world to millions of people at the same time, anything can quickly change the perception of a company and impact its stock immediately. An example would be a company that is anticipated to grow its earnings 10% on average for the next 5 years, has a solid fundamental story behind it. Then, news gets out that someone on the management team said something inappropriate and the stock drops 20% that day. The fundamentals are not expected to change over the next 5 years, but the perception based on news headlines caused investors/traders/super computers to sell the stock that day. On the flip side, there could be a company that promises to focus on space exploration and sounds really exciting. Investors flock to this company and buy its stock as it sounds exciting, but in reality, the company is actually anticipated to lose money over the next 5 years, but says it may be profitable in the 6th year. The perception of this company is that it is an exciting innovative company, which attracts investors/speculators that pushes the stock price higher, with hope that it will make money in the 6th year and beyond, which it may or may not. In our opinion, perception risk is a huge driver of short-term price volatility of a stock.
• Business/Industry Risk: a company’s stock price should follow a company’s ability to earn a profit. this profit then in turn can be used to pay a dividend to shareholders or reinvest in the company to continue to grow the business into the future. If a company’s business is poorly managed or its industry is no longer easy to be profitable in, the company’s future earnings potential is in jeopardy. Companies are not generally required to pay a dividend and stock price appreciation is not always tied directly to a company’s growth prospects over the short-term. Investing in smartly managed companies that reside in strong, profitable industries can reduce your business and industry risk.

Currencies

Currencies are a risk to investors with exposure to investments outside of their home country. As this site is dedicated to Wisconsin-based investors, we will assume the U.S. dollar is the home currency. If desired, investors can invest directly in other foreign currencies (i.e. European euro, Swiss franc, Mexican peso, Brazilian real, Canadian dollar, etc.). Currency exchange risk is the primary risk associated with investing in foreign-currency based investments. If you invest in a foreign company (i.e. Nestle, BMW, Taiwan Semiconductor, Alibaba, etc.) you have exposure to foreign currency fluctuations. Indirectly, if you invest in a U.S. company that has sales and expenses generated in foreign countries, those sales and expenses need to be translated back to U.S. dollars, which has foreign currency exchange risk assocated with it.

• Foreign Currency Risk: we’re going to separate foreign currency risk from foreign currency exchange risk for clarity. If you have an investment in a foreign government bond or a bond from a foreign company that pays you 3% interest, you expect to receive 3% interest. Or, you find a company that is anticipated to generate 5% growth in dividend payouts each year for the next 5 years. In these examples, you have an expected rate of return. Unfortunately, these investments are issued in that foreign country’s currency. If that currency, say the European euro, falls 20% relative to the U.S. dollar over your investment time period, it doesn’t matter that your bond interest or dividends were paid, the price of your investment fell 20% and overwhelmed your returns from the interest and dividend payments. The movement of the foreign currency relative to the U.S. dollar over the investment period is a significant risk to investing in foreign currencies.
• Foreign Currency Exchange Risk: Foreign currency exchange risk is when you are converting your home currency to a foreign currency and vice versa. The exchange rate is the amount of home currency units equals a foreign currency unit at any given time. For example, assume 1 U.S. dollar can be exchanged for 5 European euros today. Then 6 months later, when you want to convert the euros back to U.S. dollars, the exchange rate is now 1 U.S. dollar = 10 euros. So with only 5 euros, you only get $0.50 back in U.S. dollars, since you need 10 euros to get a full 1 U.S. dollar back, and you only had 5 euros. Foreign currency exchange rates fluctuate throughout the day, so it is important to take into account the foreign currency exchange rates when investing in foreign investments. If you have a good sense of the direction of the exchange rates, and the appreciation/depreciation of a foreign currency relative to the U.S. dollar, you have an opportunity to generate additional returns in addition to the anticipated returns of the underlying foreign investment.

Commodities

Most investors will not have direct exposure to commodities themselves. More often than not, investors can invest in derivatives that are tied to the prices of commodities. For example, if you believed the price of oil will move higher, you won’t buy a barrel of oil and store it somewhere. You could invest in an oil futures contract that attempts to mimic the changes in the price of oil. Other commodities, like gold and silver, could be purchased directly and stored, but for the average investor, if there is any meaningful exposure to precious metals, it may be through an exchange traded fund (ETF) or mutual fund that will buy the precious metals on the investors’ behalf. Supply and demand is a significant fundamental factor that drives commodity prices, but commodity futures (derivatives) have additional embedded risks that investors need to be very aware of, namely backwardation and contango.

Commodity futures are derivative contracts that often set a contract of buyers and sellers to agree on a price in the future. For example, if oil prices today are at $65 per barrel but expected to rise over the next 3 months to $70. Investors that believe oil prices will actually move to $80 in the next 3 months will try to lock in the oil futures contract at $70 that expires in 3 months. If oil prices actually get to $80 in 3 months, the investor in the $70 oil futures contract will profit $10. They essentially locked in a price to buy a barrel of oil at $70 and can now sell it for $80. Since most investors don’t actually buy and store a barrel of oil, the futures contracts allow to execute the trade on a commodities financial exchange and only money changes hands, not barrels of oil. This concept can be found across the various commodities (precious metals, industrial metals, energy, agriculture).

• Supply/Demand Risk: commodity prices are fundamentally driven by the demand for a commodity (oil, natural gas, gold, copper, wheat) and the ability to supply (oil rigs, gold mining, farmers, etc.) that demand. If demand is higher than supply, prices can spike higher. If there is too much supply and not enough demand, prices can fall quickly.
• Commodity Futures – Backwardation: when the current (spot) price is higher than the price in the futures (derivatives) market. In this scenario, the futures market is indicating that the current price of the commodity has the potential to move lower in the future. For investors in commodity futures, if the commodity price stays flat and does not move at all over time, and futures prices start of lower than the current price but are expected to move higher to the higher current (spot) price, the price of the futures contract will increase, resulting in gains for the investor in the commodity futures contract. Backwardation = better for commodity futures investors
• Commodity Futures – Contango: when the current (spot) price is lower than the price in the futures (derivatives) market. In this scenario, the futures market is indicating that the current price of the commodity has the potential to move higher in the future. For investors in commodity futures, if the commodity price stays flat and does not move at all over time, and futures prices are higher but expected to move lower to the lower current (spot) price, the price of the futures contract will fall, resulting in losses for the investor in the commodity futures contract. Contango = worse for commodity futures investors