3 Risk factors
In practice, there is almost always some element of risk (in the technical sense of ‘uncertainty’) in any investment return. There is in finance the theoretical concept of a truly risk-free asset, but at the moment it is sufficient just to be aware of the main factors causing risk or uncertainty in practice. These are:
variability of income
default or credit risk
interest rate risk.
We shall consider each of these in more detail in a moment, but first we need to remind ourselves of the principal features of each of the main forms of financial investment. The most important distinction to keep in mind is that between equity and debt.
The commonest form of equity investment is the ownership of ordinary shares (in US parlance, ‘common stock’) of a company. Ordinary shares issued by a company are not contractual obligations and have no repayment or maturity date. Unlike lenders and other creditors, investors in the shares of a company cannot legally demand their money back from the company. They are entitled only to a proportional share in:
any dividend that the company might pay out of its income; and
the capital surplus (if any) after the claims of all creditors have been paid off in a final liquidation of the company.
Shares may or may not be tradable on a stock exchange.
Debt is a contractual obligation of the company to make fixed (or at least determinable) payments of interest and principal to a creditor or group of creditors. Failure to meet these contractual commitments exposes the company to the threat of legal action for recovery of the amounts owed, as well as the possible loss of any assets pledged as security for the debt and – in extreme cases – compulsory liquidation. Debt comes in many shapes and forms, all of which rank ahead of equity in terms of their claims on the assets of a company. How they rank vis-à-vis each other depends on the contractual arrangements between each creditor or creditor group and the company. Some creditors – such as the tax authorities – enjoy a degree of statutory preference that cannot be overturned by contract. Important forms of debt are:
bank debt, which can take many forms. The simplest is the overdraft, repayable on demand. At the other end of the spectrum, syndicates of banks may make long-term loans to large companies, with complicated security provisions and covenants limiting management's freedom of action while the loan is outstanding.
bonds, which are batches of identical IOUs issued simultaneously to a number of investors by a government or by a large and creditworthy company. They typically have fixed repayment dates and require the issuer to pay fixed amounts of interest annually or semi-annually. Like shares, bonds may be tradable on a stock exchange, and this is an important factor in the investor's assessment of their relative riskiness as investments.
Note that bank debt and bonds are just examples (though important ones) of debt as a generalised idea – you are likely to meet other forms as well. This is the general background against which we now consider each of the types of investment risk.