At any given moment on a financial news channel, it seems as though a commentator is discussing the risks in the ‘market’. Most of these pronouncements fail to come with an explanation.
So what are they talking about and why should an investor care?
In his excellent book about the world of derivatives, “Traders, Guns and Money”, Satyajit Das explains risk thus:
“In reality, there are four main financial risks. If you own shares and the share price falls sharply then you lose money, this is Malta rentals market risk. Someone fails to pay you mony that you lent them or fails to perform a contract(say, a derivative agreement), this is credit risk. You may be unable to sell what you own or buy back what you are short, you run out of money to fund your positions or make payments, this is liquidity risk. Operational risk is anything that inflicts losses but isn’t market, credit or liquidity risk. Risk professionals have spent years trying to define operational risk more precisely”.
That description makes risk seem to be a little more understandable. However, there clearly is much, much more to it than that.
In contrast – and probably of more use to a Malta private investor – Warren Buffett often talks about knowledge and a circle of competence. His basic premise is that risk is reduced by understanding what you are doing. In this regard, he refers to investing (obviously) but also to understanding the business economics of the company that he is buying or investing in. He famously does not concern himself with the wider state of the economy.
Clearly then, learning more about risk analysis should be high on a list of things to do for any beginner to investing. In that regard, this Wikipedia page may be of interest.
A basic presumption is that an investor ought to earn a greater return – or have the potential for a greater total return – when more risk is incurred. Therefore, safe investments in things like government bonds and bank accounts ought to pay a much lower expected return than other assets like a property or shares in a listed company.
It is up to the investor to judge what is a fair trade between risk and return and whether the purchase price reflects this.
However, it must be obvious to even the most green newcomer to the investment world, many high risk investments and opportunities will not generate the kind of returns that justify such risk taking.
This in fact is often the folly of private investors. Many will choose to speculate on small companies that have big potential prospects, but that ultimately fail to deliver. Whether the money is lost or simply sits idly for years in an investment going nowhere, there is a cost. Opportunity cost.
An obvious question for any beginner investor to ask then is how do I lower risks and still make a reasonable return?
Another theory of Warren Buffett and his teacher Ben Graham, is the idea of a margin of safety. According to Buffett, these are the three most important words in investment.
The (very) broad outline is that an investor needs to find opportunities where there is some sort of advantage for him or her to invest. To be clear, this is not inside information which is illegal, but is instead finding an error in pricing of an asset.
For example, one part of a business may be suffering from poor trading conditions and a company’s price is impacted, but the majority of the business is fine. This could create a buying opportunity. It could be viewed as adverse PR which has an impact on the entire business valuation.
These are very large topics to which investors, traders, economists and scholars have invested thousands of hours of research. This page can never do justice to conquer your fears the subject. However, if you have learned that risk is vitally important to all investors and that understanding, reducing or controlling it is important, this page has done it’s job.