What is Risk
Definition of risk. The term “risk” is defined as “ the potential for events to occur that affect the achievement of business strategy and objectives.” It is often considered in terms of severity. In some cases, risk might relate to the anticipation of an expected event that does not occur.
This means that an entity’s business strategy and objectives may be affected by possible events. The lack of predictability of the occurrence (or non-occurrence) of an event and its corresponding impact creates uncertainty for an organization. Any uncertainty is then understood to exist for entities that aim to achieve future business strategies and objectives.
Types of risk
There are many types, from labour or legal to technological or environmental. However, in the business world, they can be divided between internal and external.
On the one hand, internal errors are those generated by the company and it is up to the company to mitigate them or have a certain control over them. Some examples are those related to operations (human error), business line (lack of diversification in the range of products for sale) or suppliers ( having one or few suppliers can leave us in a position of certain vulnerability in future negotiations).
On the other hand, there is also the external one, which is the most complex to control since its evolution does not depend on the company itself.
1. Financial risk:
Market risk: This is the risk that comes from agents related to the market, such as investors, clients, suppliers, competition, etc. In addition, this type of risk affects the fluctuations in the prices of financial instruments such as bonds, shares, etc. It also directly affects the risk factor of an investment.
Liquidity risk: This is the degree of difficulty in converting an asset into liquid money. It affects the liquidity factor in the investment triangle and is closely related to the sources of financing for companies.
Credit risk: This is the possibility of suffering losses if a company’s clients are late in making a payment, or simply default on it. This is one of the most common risks in relation to a company’s financial assets.
2. Systematic Risk
Systematic risk, also known as non-diversifiable risk or market risk, is the risk inherent to the market itself due to its uncertainty and which affects, to a greater or lesser degree, all assets existing in the economy. It is a part of the total risk of a financial asset, which is broken down into systematic risk and non-systematic risk.
This risk cannot be eliminated by adequate portfolio diversification. For example, an economic recession or a rise in interest rates negatively affects virtually all companies, at the same time and in the same direction (although not necessarily to the same extent). It can only be reduced if we do not operate in that market, and therefore, do not acquire that security. In addition, there is also the possibility of resorting to international diversification, which can help mitigate the impact of these economic events.
3. Unsystematic Risk
Non-systematic risk, also known as “diversifiable risk”, encompasses the set of factors specific to a company or industry, which affect only the profitability of its stock or bond.
In other words, non-systematic risk arises from the uncertainty surrounding a company’s business development, whether due to the company’s own circumstances or those of the sector to which it belongs. Examples of these events may be poor business results, the signing of a large contract, worse-than-expected sales figures, a new product from a competitor, the discovery of fraud within the company, poor management by its executives, etc.
These events directly affect the price of the securities issued by the company (shares and/or bonds) because investors, as in the previous case, sell and buy them based on changes in expectations about the profitability to be obtained.
Let’s keep in mind
Investment experts use volatility to determine the risk of an asset. To calculate volatility, they look at historical profitability data. This profitability data varies over time as a result of the two types of risk that exist, which, as I mentioned before, are systematic risk and non-systematic risk.
The sum of both risks is the total risk of an asset. Both systematic and non-systematic risk are motivated by a series of factors that continuously affect the prices of stocks and bonds.
Total Risk of an asset = Systematic Risk + Non – Systematic Risk
Can any type of risk be reduced or eliminated in an investment portfolio?
When I defined systematic risk, I also told you that it is known as “market risk”. All assets that make up a financial market suffer from this type of risk, so all quotes end up moving in a more or less parallel way, some more, some less. When the market rises due to any circumstance, almost all asset prices rise, and when the market falls, the same goes for it. No asset is safe, but within a portfolio, its effects can be moderated.
One way to reduce systematic risk within an investment portfolio (because it cannot be completely eliminated) is to invest in different markets at the same time. A portfolio that focuses on a single market runs the risk of experiencing more pronounced variations in its profitability than one that is distributed among several markets. In the latter case, the overall profitability of the portfolio would not suffer as many ups and downs and the reason is because, depending on the year, certain markets perform better than others. In this way, the returns obtained in each market compensate each other, stabilizing the total profitability of the portfolio over time.
As for non-systematic risk, it is different. This type of risk can be completely eliminated in an investment portfolio, which is why it is also known as “diversifiable risk”.
All stocks and bonds on the market, in addition to suffering systematic risk, bear the risk of the business or its industry, but An investment portfolio should not have to suffer this type of risk., especially that of a private investor with little investment training.
Imagine for a moment a portfolio made up of a single stock. One day this stock is discovered with news of fraud in the company and the subsequent bankruptcy of the same. The investment portfolio made up only of that company follows suit. Total bankruptcy. If that portfolio were made up of more securities, the result would not be so disastrous. For example, if it contained another stock from another company in equal parts, after the bankruptcy of one of them, the portfolio would obtain a loss of 50%. If it were made up of three securities also in equal parts, it would obtain a loss of 33%.
As the number of securities in an investment portfolio increases, the effects of negative events in a particular company are diluted over the total portfolio, reducing non-systematic risk.
So, what is the number of securities that a portfolio should have to eliminate Unsystematic Risk?
The elimination of non-systematic risk within an investment portfolio is achieved through diversification. This ensures that any negative situation that may affect a particular company is not a determining factor for the development of the portfolio.
Benjamin Graham, in his book The Intelligent Investor, one of the most influential books in the investment world, says that adequate diversification for an investment portfolio can be obtained by having 10 to 30 stocks from very different companies. Another reference in the investment world, Burton G. Malkiel, indicates in his book A Random Walk Down Wall Street, that non-systematic risk disappears with a portfolio made up of 60 stocks.
But there are still some who go even further, such as William J. Bernstein, author of other important books such as The Four Pillars of Investing or The Intelligent Asset Allocator, who states that to perfectly diversify an investment portfolio it is not enough to have thirty securities, nor sixty, nor even two hundred. The only way to eliminate non-systematic risk is to buy the entire market.
After reading this statement, you will agree with me if I tell you with complete certainty that Bernstein is the only one who is not wrong.
Concluding on Systematic Risk and Non-Systematic Risk
In this article, I have started by telling you about the two types of risk that affect a particular asset and ended by telling you how you can reduce the total risk that an investment portfolio can assume.
Within an investment portfolio, systematic risk cannot be eliminated, but it can be reduced by distributing it among different markets, either by geographic area (USA, Europe, etc.) or by type of asset (variable income, fixed income, etc.), especially if they have little correlation between them.
The risk that can be eliminated in an investment portfolio is non-systematic risk, and the best way to do it is, as William J. Bernstein says, by buying the entire market.
If you take a look at my portfolio, you will see that with very little effort I kill two birds with one stone. On the one hand, I reduce the systematic risk by distributing it among several assets based on their geographical area, and on the other, I eliminate the non-systematic risk by buying each of the markets. I achieve all of this in a comfortable and simple way by using index funds.
4. Business risk:
Strategic risk: It is related to strategic decision-making, such as entering new markets or launching new products.
Operational risk: Involves internal issues in the management of a company, such as supply chain management, cybersecurity or human resource management.
Reputational risk: In this case, the risk consists of the exposure to which a company is subjected at the level of social networks and public opinion.
Legal and regulatory risk: This is the risk that legislation may undergo some type of change and may have a detrimental effect on us, directly or indirectly. Therefore, companies must take these into account to mitigate any possible negative consequences.
5. Personal risk:
Health risk: Includes illnesses, injuries or health problems that may affect a person.
Life-threatening: Refers to situations that endanger a person’s life, such as serious accidents.
Security risk: Covers threats to personal safety, such as theft, assault or aggression.
Longevity: Linked to uncertainty about how long a person will live and how they will support themselves financially in retirement.
6. Other risks:
Force majeure: This is the unpredictable risk of catastrophes or natural disasters that may affect the company. This type of risk is unavoidable for companies. However, it must always be taken into account when establishing a location prone to the occurrence of this type of danger.
Technological: Refers to problems related to technology, such as cyberattacks, computer system failures or disruptive technological changes.
As you can see, there are many risks. Some depend on the good performance of the company internally, and others must be taken into account externally. The latter are the ones that can cause the most problems if there are no contingency plans in case of unforeseen events. At the accounting level, reserves for unforeseen events are usually used. On the other hand, at the financial level, diversification is usually a good tool to dilute the inherent risk of the market.
Risk management
When assessing company risks, it is very important to know how to identify and combat them. Risk management is the tool that companies use to identify, analyze and respond proactively to the different problems they may experience.
With effective risk management, companies can detect any potential problems and mitigate them in order to continue their activity effectively and achieve their objectives. This process must be carried out periodically, trying to incorporate constant improvements to benefit the procedure and immediacy of the results.
A risk management plan, apart from helping you deal with risks, helps you understand the optimal risk levels for a company, improves capital allocation, takes care of the company’s corporate image, etc.
Difference between risk and danger
To correctly understand this concept, we must know how to differentiate it from the concept of danger.
The main difference between both concepts is that danger refers to an act or situation that may cause potential harm, while risk refers to the probability of a dangerous event occurring and the severity of its consequences.
To illustrate the differences between the two concepts in a work context, we can refer to a kitchen. For example, working in the kitchen with knives or hot oil is inherently dangerous.
But the risk of cutting or burning (probability of being cut or burned) will be different for a cook who is using, for example, the necessary clothing than for one who does not comply with risk prevention regulations.
In addition, the severity of the risk will also be different if the cook is working near the oil or with very sharp knives than for other cooks who are further away from the oil or who use non-sharp utensils.
Below are some examples of risks:
1. Occupational risk: Risk that can lead to an accident during working hours. An example would be if we were to be a cook and accidentally burn or injure ourselves with a kitchen utensil.
2. Technological risk: Any risk related to a technological component. An example is the risk incurred if a company has all of its data on hard drives, which can be cyberattacked.
3. Environmental risk: This is related to the possibility of an unforeseen event occurring, both from our company to the environment and from the environment to our company. The spillage of toxic substances or an animal damaging a company asset are clear examples, respectively.
4. Solvency risk: In this case, an example would be the risk assumed by a financial institution when lending us money, since a possible default could occur.
These are some examples of the different types of risks that exist, although they are not the only ones that can occur.
