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What is risk? – Equities

In this series of articles we are considering the different TYPES of RISK we take when investing in different assets. This should help to build a portfolio in which we fully understand what risks each part of the portfolio expose us to.

What are equities? – known  as stocks or shares they are a ‘share’ in a company. As a part owner of that company we must therefore SHARE in its profits (and losses). If the company goes bust we cannot expect not to share in this and lose (normally) everything we put in! Likewise if it is very profitable then we would hope to be rewarded as owners should be (by dividend or share price growth… or both); the performance of shares is well documented and on average they outperform most other assets over the long term but do we really understand all of the different types of RISK we take as investors in shares?

Asset risk – if equities themselves, as an asset class, are out of favour then they tend to all fall together if concerns about future growth (and therefore profits) are prevalent, this can be irrelevant of the market or sector you are looking at, which may have robust fundamental reasons to invest in it but is still knocked by the market selling off all equities.

Market or Correlation risk – many major stock markets are very highly correlated, so even if you have a diverse portfolio of European, US and UK stocks, for example, you can lose on all of them if they are highly correlated.

Sector Risk – companies all do different things, provide different services and make different goods, but sometimes a whole sector will be out of favour so losing value in what is a good company may still happen if the sector it is in is not loved.

Company specific risk – this is primarily down to the quality of the board of the company and the vast majority of company directors want their companies to do well; but their share price can also be affected by regulatory changes, legal actions, competitors, patents etc. no matter how good a company may be it is not bullet proof and so different companies will perform better in different parts of the market cycle.

Liquidity Risk – if you decide to buy smaller companies which aren’t very well known then there may be a minimal ‘market’ for them… this means that if you can’t find a buyer then you either can’t sell them at all, or you accept a lower price. Most shares are traded on regulated stock exchanges and so liquidity of all but the smallest companies tends to be good.

‘Shares are the only things we don’t buy on sale’ so all of the above risks, like with most assets, can create buying opportunities. It is often best to access shares via funds as the daily choices and control are managed by a professional manager, you can then also access many different sectors and markets with relatively small portfolios.

It is vital to understand the different types of risk so your overall asset base is not over exposed to one type of risk. For example someone with a large property portfolio (liquidity risk) shouldn’t then invest in small companies but should have more money in cash (inflation risk), high quality bonds (interest rate risk) and ‘blue chip’ shares (market risk).

This article is for information only and should not be considered as advice.
This article is written by Peter Brooke The Spectrum IFA Group

More on risk and investing in different assets