ACCUMULATING AN EMERGENCY FUND

The highest investment priority for any individual or family unit is to establish an adequate emergency fund. Every individual need to have access to a fund that can support emergency spending needs for such things as unexpected medical expenses, ordinary living expenditures during a short-term period of unemployment, or the replacement of assets that are unexpectedly lost. Even though each of these loses may be at least partially offset with appropriate insurance coverage, individuals will nearly always encounter unexpected monetary needs. Because an emergency fund is designed to provide for unexpected difficulties, safety of principal, stability of value, and excellent liquidity are the prime considerations for assets that are selected for such a fund. These strict restrictions eliminate the majority of investment vehicles from consideration. For example, common stocks, intermediate- and long-term bonds, preferred stocks, real estate, and gold bullion are not considered suitable investments for emergency funds. These investment vehicles are all short of safety, stability, and liquidity.

IDENTIFYING INDIVIDUAL GOALS

The initial step in controlling risk is to identify the goal or goals that an investment program is designed to achieve. It may seem unlikely that a rational person will invest funds when no specific motives have been identified. Investments can be made only at the expense of reducing current consumption, and few find pleasure in giving up many of life’s pleasures. The truth is that individuals all too frequently acquire investments without really defining what it is that they expect the investments to accomplish. Identifying goals is crucial to establishing an intelligent investment program, because an individual’s goals play a major role in determining the risks that can be tolerated and, hence, the kinds of investment assets that should be acquired. For example, if achieving a particular goal is deemed to be absolutely crucial, then certain restrictions apply to the investments that are to be acquired in pursuit of the goal. The same limitations may be less important or even irrelevant when the achievement of a goal is desirable but not really critical.

RISKS OF DEALING IN FUTURES CONTRACTS

The risk from investing in futures contracts to a large extent depends on how the contracts are used. If a contract is used to offset another investment position, then a hedge is initiated and the risk of an investor’s position is reduced. For example, a farmer concerned about the price that would be received for a crop at the time a price ahead of time. Using a futures contract in this manner actually reduces risk. The farmer has locked in a price and essentially eliminated any uncertainty as to the revenues that will be received from selling the crop. Likewise, a business that plans to make a large purchase of goods from a foreign manufacturer in the home currency of the manufacturer runs the risk that the foreign currency may appreciate against the dollar before payment is due. To reduce the risk of buying the goods, the business can purchase a futures contract on the foreign currency, which would affect any changes in the rate of exchange between the dollar and the foreign currency. An investor holding a large portfolio of common stocks can engage in a hedge by selling one or more futures contracts on a stock index.

RISKS OF BUYING AND SELLING OPTIONS

Depending on how options are used, investors can be subject to substantial risks. Losing the entire amount spent to purchase a call option or a put option is not an unusual event. Investors who write options are subject to the possibility of losing substantially more than the premium received. Option prices are volatile to the point that their relative values change by a multiple of the change in the underlying stock. Thus, anything that can bring about a change in the price of the underlying stock in a short period of time has the potential for producing great loses for the owner of a stock option. On the other hand, purchasing-power risk is of no great concern to an investor in options, because put and call options typically expire in a matter of a few months. If a option position is established in combination with another investment that is purchased or is already owned, the result may be that an investor’s uncertainty is reduced.

CONVERTIBLE BONDS

It is not really possible to understand the risks of owning these hybrid securities until the uncertainties relevant to both bonds and common stocks have been discussed. Convertibles take on most of the risks of each category of security while tending to moderate these same risks. As a result, these securities appeal to investors who desire to straddle the fence between bonds and common stocks. Convertible bonds are debt securities an investor can exchange for something else, generally, a fixed number of shares of common stock of the same firm. Convertibles are issued as delayed equity financing with the expectation that the bonds will eventually be converted. Companies have a variety of motives for issuing these bonds. For one thing, convertible bonds lower the interest rate at which the firm can borrow money compared to what would be paid if regular debt was issued. Also0, the firm’s managers may feel that the market price of the company’s stock is currently depressed, and they do not want to sell new stock into a weak market.

THE IMPORTANCE OF A FIRM’S LINE OF BUSINESS

The effect of inflation on a firm’s earnings and asset values depends in large part on the kind of business in which a firm is engaged. A business that produces goods or services for which it is relatively easy to raise prices may find that unexpected increases in inflation are fairly painless or perhaps, even desirable. The stockholders are thus likely to avoid much of the pain associated with inflation, although there is no reason to expect that dividends and the stock price will always move in proportion with inflation. Another important aspect of the extent to which a business will be able to compensate for unexpected inflation is the mix of the resources it employs to produce goods and services. Businesses that use large amounts of labor or significant quantities of price-sensitive materials are likely to discover that, proportionately, their costs increase more than the general rate of inflation. Even though these firms can raise the prices of their goods and services, they may find that cost increases outrun revenue increases, so that earnings are penalized. On the other hand, firms that use large amounts of fixed assets may find that their expenses increase only marginally, at least over the short or intermediate term.

HOW INVESTMENT RISKS INTERACT?

It is challenging enough that investors must concern themselves with identifying all of the individual risks applicable to the tremendous variety of investments available for purchase. A second and equally aspect of risk analysis is how risks frequently interact with one another and how the interaction affects rates of return. Some types of risk tend to operate independently of other risks, so that analyzing the effect of the uncertainties on an investment’s rate of return is a relatively straightforward matter. For example, liquidity risk is an uncertainty unique even to different investments of the same general type. Many issues of bonds subject investors to significant amounts of liquidity risk, while other bonds can be sold quite easily. Other risks act in concert to affect the rates of return acting together frequently produces a different result than would be expected on the basis of a single risk. If the risks influence the investment’s return in a similar manner, then the two risks reinforce one another and increase the volatility of the investment’s return.

MARKET RISK

Market risk is the uncertain of return caused by market cycles, sudden market movements, and changes in public fashions among investment alternatives. Although market risk is unique in that the uncertain return applies to a particular investment or class of investments, it is a risk caused by factors that have little to do with the fundamentals of the investment. Market risk is more a matter of investor psychology than it is of financial analysis. Market risk is especially important to investors who may need to liquidate an investment on relatively short notice. The risk is that the liquidation may occur during a down portion of the investment cycle.

FINANCIAL RISK

Financial risk refers to an investor’s uncertain rate of return because an organization may be unable to meet its financial obligations. These obligations generally consist of interest and principal payments on borrowed funds. Investments in organizations that are heavily in debt tend to subject their owners to greater uncertainty of return because of financial risk. Unlike other forms of risk that can result from numerous sources, financial risk is caused by a single factor; incurring fixed financial obligations. These obligations may result from a desire to acquire more assets or from a need to obtain funds to meet current spending requirements. These obligations generally result from debt, although leases can be equally burdensome and produce financial risk. The more money an organization owes relative to its size and the higher the rate of interest and principal obligations will become a problem for the organization. Financial risk is that simple. It applies equally to businesses and government organizations.

BUSINESS RISK

Business risk refers to an investment’s uncertain returns because of the uncertain business environment in which the organization operates. This poor performance may be the result of unwise management decisions or inefficiencies in the delivery of products or services. It may also be caused by events external to the entity, such as a change in the value of the dollar relative to other currencies, which makes it difficult for a firm to compete. And there is always the possibility that a new competitor will emerge and knock the socks off a company that has been operating in a sheltered environment. One could argue that uncertain rates of return caused by events such as these can more accurately be called organizational risk. The risk is that an investment will produce volatile returns because of some uncertainty relative to the organization in which the investment is made. Business risk is classified as unsystematic because it results from occurrences unique to a particular investment or to a particular organization.