Carson Investment Research recently published our 8 Principles of Equities. Now it’s time to dive a bit deeper into our 3rd Principle – Reward takes Risk. At the surface, this seems obvious. Stocks are volatile, and investors need to be compensated for that added risk compared to other asset classes. We touched upon this with our first principle – Nothing beats long-run equity returns. While financial academia leads many to believe that volatility is the sole definition of risk, it’s just one aspect of it. In fact, some would argue that it’s the least important risk type despite it being the easiest to understand and quantify. Nevertheless, we feel that it’s important to understand the various risks that come with equity investing. As Warren Buffett once said, “Risk comes from not knowing what you’re doing.” There are many types and subcategories but we feel that these are the most important risks that equity investors should be aware of.
Market Risk
This is the best-known risk type – price volatility that stems from the overall fluctuations in financial markets. It’s not specifically associated with a particular sector or company but rather an entire market, which could be equities, interest rates, commodities, or currencies. This risk cannot be diversified away but it can be mitigated by having a long investment horizon.
Business Risk
Basically, this is the fundamental risk of a sector or company. We would argue that it’s the most important for long term investors. Business risk encompasses a lot, including risk from competition, the overall level of demand for goods or services, profits, execution of corporate strategy, etc. Basically, does a company or sector have a viable business model that can sustain over many years? Usually, if a stock or sector is meaningfully outperforming or underperforming the broader markets, it is due to business risk, or the anticipation of it materializing.
Credit Risk
This is the added risk that comes from a company or group of firms that use debt to fund their business. Will they be able to pay their principal and interest obligations? Equity investors are subordinate to bond holders, so if a company defaults, they are last in line and are usually left emptyhanded.
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Liquidity Risk
This is the ability to buy or sell a stock for the stated price. This is an obvious risk for private market investors. However, for public equity investors, this risk type has lessened over the years as bid/ask spreads have shrunk materially once markets moved away from fractions to decimal quotes. Yet, for some parts of the market like small cap stocks, investors should expect some price loss from transacting buy and sell orders. Thankfully it is typically minor though.
In summary, volatility is the best-known risk type, but we would argue that it’s less important for longer-term investors. Big drawdowns are undoubtedly scary and nerve-racking, but for the intelligent investor it can mean opportunity. Lower prices today translate into higher future returns as we noted in our 2nd Principle – The Stock Market is Built to Recover. Understanding the various types of risk that accompanies equity investing is imperative to sticking to your plan and reaping its rewards.
