The definition of risk can be tricky. The term is often tied to a “bad” thing (downside risk), but it can also be a “good” thing (upside risk). According to the ISO 31000 standards, a set of guidelines for Risk Management, the risk is defined as the “effect of uncertainty on the objectives”.
In my humble opinion, this definition is perfect if applied to the downside risk. You wouldn’t care to end up richier than your initial goal (upside risk), but you will avoid to end up poorer (downside risk). In this article we will mention some of the risks faced while investing in the capital market along with the basics of cost of capital.
Types of Risk
The risks can be divided into two main groups: unsystematic and systematic risks.
Unsystematic (specific) risks are related to the investment itself. So, if you are investing in Tesla or Exxon stocks you will face specific risks related to each company and market segment. A shift in management, regulatory change, price of oil, and consumer spending are just a few examples.
According to the Capital Asset Pricing Model (CAPM), a very well-known theory in the field of Finance, investors hold diversified portfolios to minimize risk. This means that is possible to achieve a higher portfolio return and lower risk through diversification until a certain point.
But (there is always a but) isn’t possible to diversify the systematic risk because it’s related to the entire market. Here are some examples:
- Interest rate risk: Diversification can’t decrease this risk, so you will have to bear it. The interest rate is a strong tool of monetary policy and can change many times to control other variables like inflation, growth, and spending. You can take a look here and learn more about the Federal Reserve’s decisions about inflation rate in the United States;
- Currency risk: This risk is related to the performance of a currency in relation to USD or any other basic currency that can affect the investor’s performance. An American investor, for example, can make a great investment overseas in nominal terms that ended up being bad in real terms after taking the exchange rate between the currencies into consideration. You can read this interesting article about China’s Central Bank and Yuan depreciation;
- Country risk: This is associated with the country itself, particularly related to political reasons and the economic capability of an exchange country to honor its debts. This metric is often added to the cost of capital. Countries like Venezuela and Argentina have a much higher rate than the United States and Germany. This means that the investors will ask for a higher return to invest in these countries to compensate for the higher risk that they will face. This is one of the reasons why the interest rates in these countries are so high.
You can dive deeper into types of risks here, here, and here. As shown so far, the systematic risk can’t be diminished through diversification. This means that it must be borne by the investor. How does it work in an investment decision? We need to talk about Beta and the Cost of Capital.
Systematic risk
We’ve talked about the Cost of Capital here. The equation is very simple and intuitive. Take a look at Figure 1 below that shows the Risk-free asset, Market risk premium, and Beta:
As shown, the Cost of Capital equals the sum of the Risk-free asset rate, and the Beta times the Market risk premium rate. There is no “Risk-free” asset in the economy, so in this case we should consider the rate of the most secure assets which are the US government bonds (T-Bonds). Some national regulatory agencies around the world can use their country’s bonds as Risk-free assets, but this isn’t possible for the main conception of the CAPM theory.
Let’s think about the dynamic of an interest rate rise, the same that we’ve been facing since the start of the COVID crisis:
- If the interest rate goes up, people will be willing to spend less today to invest in bonds (or any other investments that are directly related to the interest rate);
- The Risk-free asset rate will rise and the Cost of Capital will be more expensive;
- The investor can now receive more to just “park” its money on bonds instead of taking a risk in the capital market;
- Leveraged companies (almost 99% of the capital market) will have their cash flows more pressured by a higher interest rate that can diminish the market risk premium);
- The Cost of Capital goes up. The investor’s money is now more expensive;
- If the investor was willing to pay $10 for a stock yesterday, he may be willing to pay just $7 today;
- Stocks will be repriced to match a new cost of capital.
But… what happens with the Beta? If the Beta represents the systematic risk and the investor can’t diminish it through diversification, how this indicator is calculated?
Unfacing the systematic risk
The first thing we have to do is to set a benchmark. The capital market usually takes the performance of the S&P 500, so let’s just do the same. Figure 2 shows the daily prices of the S&P 500 for the last 5 years:
In order to calculate the systematic risk we need to choose other assets to compare with our benchmark. In this example, let’s get TESLA (TSLA) and Exxon Mobil (XOM). Figure 3 and 4 shows the daily prices of the last 5 years for, respectively, TSLA and XOM:
Risk and volatility
In the capital market, the risk is often perceived as volatility. A stock that changes 10% in a determined period is said to be riskier than another stock that only changes 4% in the same period. Sadly, this is a completely wrong perception.
If a company is managing to deliver increased revenues, cash flow, and margins, then it makes no sense to analyze the risk of this company in relation to its stock price volatility. A company with a high leveraged and decreasing revenue has a much higher probability to go bankrupt than another company with low leverage and increasing revenue independent of how their stocks are behaving in terms of price.
But, since volatility and risk walk together in the capital market, let’s keep going with our example. Now that we already have Figure 3 and Figure 4 showing the daily prices in the last 5 years, we need to calculate the percent of change between each day.
Figure 5 shows the daily percentage of change for Tesla.
Figure 6 shows the same calculation for our benchmark, the S&P 500. Note that TSLA seems to have higher volatility than the S&P 500 below. This happens due to a clear reason: S&P 500 is a portfolio that combines 500 assets that represents a high percentage of the most important companies in the world. Highly diversified.
The Beta calculation
We need one more step to calculate the Beta from the percentage of daily change. We need to plot all of the percentage daily changes of an asset in the y-axis and the percentage daily change of the S&P 500 in the x-axis so the behavior of the stock price will be a function of the behavior of our benchmark.
This helps to answer the following question: If the capital market moves, how the asset will move?
Figure 7 shows the dispersion chart for the values of TSLA and the S&P 500
Where is the systematic risk? Pay attention to the blue line that fits the points. This line is positioned so the distance of the points to the line is the lowest as possible. The angle of this line in relation to the x-axis is called “Beta”. Note that there is an equation in the chart as follow “y = 1,4716x + 0,0013”. In this case, Beta equals 1,4716. Save this number and head to Figure 8.
Figure 8 shows that Beta equals 0,90. What does all of this mean?
- If Beta > 1: the asset price is more volatile than the market;
- If Beta = 1: the asset price is as volatile as the market;
- If Beta < 1: the asset price is more volatile than the market.
This means that Tesla was more volatile than the market in the last 5 years. If the market went up 1%, then Tesla would have gone up about 1.47%. But, if the market went down 1%, then Tesla would have gone down about 1.47%. This is what the capital market calls “risk”. It can go up (upside risk), but it can also go down (downside risk).
As for Exxon, the calculated Beta was 0.90 (less volatile than the market). This makes perfect sense since Exxon is in the energy sector with a much more previsible revenue than Tesla.
Conclusion
We all know that past performance is no guarantee of future results. But, considering that it is, what do you think would add more risk to a diversified portfolio: Tesla or Exxon?
Certainly Tesla, but this doesn’t mean that you should add Exxon just to have lower volatility (risk). This means that you need to understand how much risk you can bear and add the right assets to your portfolio. Not the other way around.
Some investors can’t even add any stock because they can’t sleep well when the portfolio moves 1%, but sadly many keep doing it. Many investors are building their portfolios without any knowledge of risk return. Investing is a combination of psychology and economics. Your mind will play tricks on you.
Much more important than understanding all of the mathematics that surrounds these concepts (which isn’t crucial for your success as an investor) will be to understand your risk profile. Balancing your portfolio well and respecting your risk appetite is one of the most important things to end up your investment journey with good mental health, because if you lose this, then you’ll lose everything.
Disclaimer
The stock analysis presented on Echo Chamber site is meant to be used for educational purposes and doesn’t represent any kind of financial advice such as buying, selling, or holding shares of any particular stock. Past performance is no guarantee of future results. Investments in variable income can result in the loss of wealth.
The objective of this analysis is to didactically present just a few metrics that can be used to analyze an asset. A full analysis must go further and consider many other financial statements like the income statement, balance sheet, and complete cash flow.
In addition to that, knowing the company, the sector, the economy, and the administration’s guidelines about the company’s future along with basic knowledge of corporate finance are required in order to perform a full stock valuation.
It’s strongly advisable that any investor conduct their own research on any company prior to investing in it. Any suggestion from third parties should be carefully analyzed and used as input, a part of the information needed in the investment decision-making process.
The choice of using the TradingView platform it’s personal without any commercial purpose. I consider this platform one of the best available in the market. The free version offers enough resources for a good analysis, but the paid plans can also offer much more value depending on the investor’s objectives and expertise to use the information available.