Broadly speaking, investors are rewarded for 2 main types of risks that they take – market risk and credit risk:
Very simply, market risk refers to risk of price movements of your investments. For example, the risk that share price of Company XYZ will plunge after you’ve bought its shares; or the risk of interest rate going through the roof after you’ve committed to a mortgage on an investment property. Or maybe you’ve converted some Singapore dollars into Australian dollars, and the exchange rate has now moved against your favour – that’s also market risk. If you are someone working in the financial world, one way to measure market risk is using the variance at risk or VaR technique. However, since this column is intended for retail investors who are largely laymen, we shall not be discussing the technique since it involves a great deal of complexity.
It should be noted that given the uncertainty of market directions in general (there is no guarantee that you will get your original capital back), the reward for engaging in market risk – that is, capital gain – typically far exceeds that of credit risk. As we mentioned in the last blog post, high returns normally accompany high risks, low risks low returns.
Many retail investors are familiar with the concept of market risk but few know how to deal with it. Most financial planners would advise that during your younger years, it would make sense to allocate a bigger proportion of your investments in taking market risks such as buying shares; reason being, you would most likely have time to ride out market volatility in the long term (that’s one of the ways to deal with market risk). Likewise, as you advance towards old age, it would make more sense to switch progressively into credit risk-type investments, given that there is limited time to withstand volatility.
If you are the kind of investor who have little or no tolerance for any loss of capital, in anticipation of any potential capital gains, then you may want to take less market risks. Remember that there is no free lunch when it comes to risk-return trade off. Timing is a crucial factor in deciding on your entry and exit levels in market risk type investments.
Credit risk is the risk of loss due to non-payment of a certain party. For example, your friend David borrowed $500 from you and promised to return it within 2 weeks. Assuming that you know David is out of job, and there is a high possibility that he won’t be able to return you the sum of money within the stipulated period –> that’s credit risk. Similarly, when you place a 3-month fixed deposit with a bank, you are in fact lending money to it for 3 months, after which you expect it to return your capital to you, with interest as reward for taking the credit risk involved. Other than deposits, bonds (we are talking about real bonds here, not mini bonds which are in fact credit linked notes) are another form of credit risk type investment. We will be discussing these investment products in details in later posts.
Certain asset classes are deemed to be a mix of the two risks, such as property investment (that is, buy-to-lease). There is market risk if the price of the property plummets after an investor purchases it. However, if he does not intend to sell the property anytime soon, he would likely be concerned about his tenant’s credit risk (that is, risk that his tenant may not have the ability to pay him). That is, the investor has exchanged market risk for credit risk in the near term, while waiting for a meaningful reward for taking market risk.
Here is an exercise for you: Decide on what combination of market/credit risk appeals to your risk appetite. Remember, there is no free lunch.