South Florida, including Boca Raton, Delray Beach and West Palm Beach Business and Corporate Attorney:
Risk is defined by Webster’s Dictionary as “the chance of injury, risk or loss.” In the investment arena risk can be defined in a number of ways:
- with respect to fluctuating market values of securities and portfolios, risk means the exposure to uncertainty, which is manifest as variability (or, synonymously, volatility), and is measured by standard deviation.
- the uncertainty related to the outcome of an investment
- the variability of returns from an investment
- in its stricter and narrower sense, risk means the potential for loss of value.
When you are establishing your financial objectives, it is important for you to consider the amount of risk that you would be willing to expose your financial plan to in order to achieve your financial goals. It is for this reason, when you open your brokerage account, the account executive is required to review with you, among other things, your investment objectives, including risk. By way of example, I recently was looking at a new account document, which provided the following risk choices for the client to choose from: (1) safety of principal, (2) growth, (3) aggressive growth and (4) speculation (please note that some of these terms are also associated with the underlying investment objective). Usually these terms are not defined in the new account documents that are signed when your account is opened. Consequently, it is important for you and the account executive to have a meeting of the minds concerning these terms. Clearly, if you have a risk tolerance of growth, you don’t want the account executive soliciting your investment in a speculative security.
When discussing risk with your account executive, some of the commonly encountered types of risk that will or should be highlighted are:
- Business risk – includes the uncertainty that pertains to a company’s sales and earnings, namely, that a company generates poor sales and earnings for a period of time. By their nature, some companies are riskier than others, and the riskier companies usually see greater fluctuation in their sales and earnings.
- Management risk – includes the stability of management and the effect that it has had on sales, earnings, and future growth.
- Financial risk – is the inability of a company to meet its financial obligations. One of the ways that financial risk can be measured is by the amount of debt that the company holds in relation to its equity. A company with a high proportion of debt relative to its assets has an increased likelihood that at some in time it may be unable to meet its principal and interest obligations.
- Unsystematic risk – is the risk, specific to a company or industry. This risk pertains to a company’s business, its operations, and its finances.
- Market risk – refers to the movement of securities prices, which tend to move together in reaction to external events, unrelated to a company’s fundamentals. Market risk is the risk that market pressures will cause an investment to fluctuate in value. Many investors believe that although you can diversify investments to virtually eliminate business, financial and operating risks, you cannot do the same with market risk. Diversification does not provide a safety net when an external event causes a decline in the stock markets.
- Interest rate risk – is the rise or fall in interest rates that affects the market value of investments. Interest rate risk refers to changes in market rates of interest, which affect all investments.
- Inflation risk – is the risk that changes in consumer prices will erode the future purchasing power of returns from investments. If prices in the economy rise (inflation), your future dollars will purchase fewer goods and services than they do today.
- Event risk – is broadly defined as the possibility of the occurrence of an event specific to a company that could affect its bond and stock prices. Event risk can arise from a number of factors such as political upheaval, government intervention, natural disasters etc.
- Exchange rate risk – is the risk that the exchange rate of a currency could cause an investment to lose value. An increase in the value of the dollar against a foreign currency could decimate any returns and result in a loss of capital when the foreign securities are sold.
- Liquidity risk – is the risk of not being able to convert an investment into cash quickly without the loss of a significant amount of invested principal. Certain securities are more liquid than others; the greater the liquidity, the easier it is to buy and sell the investment.
A direct correlation exists between risk and return: The greater the risk, the greater is the potential return. However, investing in securities with the greatest return and, therefore, the greatest risk can lead to financial ruin if everything does not go according to plan. It is for this reason that you have agreement between you, as the investor, and your account executive as to the level of risk that you are comfortable with. Also, depending on any number of factors, the risk that you are willing to take may increase or decrease with time or circumstances. In such a case, it is imperative that you communicate this change, in writing, to you account executive.
Please keep in mind that risk is not only related to a particular security or industry segment but also to the overall trading strategy that is employed in your account. If you believe that you have suffered damages as a result of broker fraud or misconduct relating to the degree of risk associated with the operation of your account, please contact the law office of Russell L. Forkey for your initial consultation.
The primary focus of this article relates to the relationship between a customer and his broker. However, many of the concepts concerning risk apply equally to simply investing directly in a small to large business venture.