Investment Risk

1. Risk

Risk is defined as the uncertainty of returns, encompassing the possibility of both gains and losses in an investment.
"Individuals won’t take on additional risk unless compensated by an additional return."

2. Types of Risk

• Systematic Risk (also known as Market Risk or Undiversifiable Risk):
  • This risk is inherent to the entire market and cannot be eliminated through diversification.
  • Examples: changes in interest rates, recessions, wars.
• Non-Systematic Risk (also known as Specific Risk, Diversifiable Risk, or Residual Risk):
  • This risk is unique to a specific company or industry.
  • Examples: labor strikes, rumors of a potential default, landslides affecting a mining company.

Risk vs. Return

1. Return

Return is defined as the increase or decrease in the original purchase price of an investment. Generally, a higher rate of return is associated with greater risk.

2. Risk-Return Trade-Off

The risk-return trade-off reflects that with higher potential returns comes greater risk. "Individuals won’t take on additional risk unless compensated by an additional return."

Risk Preference

Definition

Risk preference refers to the attitudes individuals hold towards risk, influencing investment decision-making. In finance, it’s assumed that investors are risk-averse, meaning they avoid risk unless they are compensated by a higher return.

Risk Aversion

Refers to the tendency to avoid risk. Risk-averse individuals maximize returns for a given level of risk or minimize risk for a given level of return. Higher returns are required by risk-averse individuals as the risk level increases.

Risk Measures and Risk Reduction

1. Risk Measure

• Variance and Standard Deviation: Fundamental risk measures for a single asset.
• Coefficient of Variation (CV): A simple risk-return measure that compares various assets. Calculated by dividing the standard deviation of returns by the mean return.
• Example for Stock X: CV = 0.05477 / 0.1685 = 0.32504. A lower CV is preferred by risk-averse investors.

2. Ways to Minimize Investment Risks

1. Determination of Tolerance to Different Kinds of Risks
   • Tolerance factors include net worth (assets minus capital) and risk capital (money that won’t impact lifestyle if lost).
2. Conducting Due Diligence
   • Involves researching investment instruments before finalizing an investment. Check the investment’s history, earnings growth, management team, and debt load.
3. Diversification of Investment Portfolio
   • Spreading investments across various asset types to reduce overall risk.
4. Monitoring of Investments
   • Regular evaluation and reallocation of resources to maintain the intended portfolio allocation, based on factors like age, investment period, and temperament.
   • Example Portfolio: 40% in intermediate bonds, 25% in large-cap stocks, 10% in short-term bonds, etc.
5. Taking Advantage of Government-Guaranteed Investment Products
   • Government-backed instruments, like Treasury bonds, offer a safe investment option as they are insured by entities like the Philippine Deposit Insurance Corporation.

Short-Term Investment Strategies

Buying on Margin

Buying on margin allows an investor to borrow part of the funds needed for stock purchases from a brokerage firm.

Example: With a 50% margin requirement, if you want to purchase Php2,000 worth of stock, you can borrow up to Php1,000.

Long-Term Investment Strategies

Diversification

Diversification is the strategy of spreading investments across different assets to minimize risk. "Don’t put all your eggs in one basket."

Risk - Return Measure

Variance

Variance measures the degree of risk in an investment. High variance implies higher risk with the potential for a higher return, while low variance implies lower risk and lower return.

Coefficient of Variation

CV = σ / R_mean. This measure helps compare assets by showing how much risk is taken per unit of return. Investors typically prefer assets with a lower coefficient of variation.