One of the great strengths of dividend Investing is that it helps mitigate risk – I have made this point in the past and will certainly refer to it numerous times in the future. However, it might be reasonable to question what types of risk we are seeking protection from and how important these elements of risk are to the well-being of our portfolio.
The two types of risk that affect the value of our stocks are systematic risk and unsystematic risk.
Systematic Risk
Systematic risk refers to the risk that is inherent in the market. It is associated with macroeconomic factors that cannot be anticipated or avoided, such as wars or natural disasters. Because it affects the entire market it cannot be removed through diversification.
Systematic risk falls into four categories – market risk, interest rate risk, inflation risk, and exchange rate risk.
Market Risk
There is a herd mentality within the market and we see it all the time. A stock moves up, more people buy it, which in turn causes it to move up even more, so even more people buy it. This also happens when a stock falls. These movements flow through the market and affect it as a whole.
Interest Rate Risk
Interest rate risk primarily (and severely) acts on bonds. Bond prices are inversely related to the interest rate. This is because when interest rates go up the investor can find a better rate of return somewhere else, so to compensate the bond price needs to be adjusted to stay competitive.
Inflation Risk
Inflation risk directly affects fixed income securities. Inflation affects purchasing power – what could once be bought with a certain amount of money can no longer be done. When I was young I remember being given a dollar and told to get a gallon of milk and a loaf of bread – and bring home the change. This is inflation, and why leaving money in a savings account, while safe, will result in a loss.
Exchange Rate Risk
Exchange rate risk affects companies that have exposure to foreign currency. Each day the value of the U.S. dollar can rise or fall as compared to the currency of other countries. So if the value of the dollar falls against the value of the Yen and a company needs to buy parts from Japan, then those parts will cost more.
Unsystematic Risk
Unsystematic risk is specific to the company or industry. Examples of this might be business risk, legal risk, political risk, etc. This type of risk can be abated through diversification, so holding a larger number of companies in one’s portfolio that are in different industries can be helpful in this regard. That is why investing in an S&P 500 index fund is a good idea.
Measuring Risk
Measuring risk is an essential aspect to understanding how much risk a particular security might be holding. Above we have seen a quick overview of the types of risk one might expect to encounter, but quantifying the risk can get us to a bottom line number of exactly how risky things might be.
Measuring systematic risk is usually done through the capital asset pricing model (CAPM). That is about all that I am going to say about the subject.
Although certain elements of systematic risk are less important to the dividend investor, he or she does need to keep market risk and exchange rate risk in mind.
As far as market risk is concerned, I think of companies that maintain a high (P/E) as being particularly susceptible to market risk. This is because a high P/E means that the company is valued higher than others, as the expectations are much greater and higher earnings are expected.
It is common to see that when a company’s quarterly report does not meet the elevated assumptions of analysts, investors leave in droves because they understand that their lofty expectations were not met. This is noticed and followed by other shareholders, with the resulting lowering of the value of the stock. For a good company this could actually be an appropriate entry point for the long term investor, if the behavior appears to be irrational when looking at things on a long term basis. Securities that are expected to be held for years place less importance on the numbers of quarterly reports and the short term expectations of analysts than the long term prospect of the company.
As far as exchange risk is concerned, the more international exposure the company has, the more concerned one should be. Manufacturing companies are especially susceptible to the ups and downs of currency exchange rates. Trade wars can also affect the cost of goods that these companies use to make their products.
These two issues, market risk and exchange risk, are items to be aware of, but quantifying them are exceptionally difficult. The takeaway is that for the dividend investor, outside of realizing that international exposure increases exchange risk, we should lessen our concern with systematic risk as it is simply the risk of holding stocks in the first place, and concentrate on unsystematic risk.
Summing Up Risk
Understanding risk helps us create strategies based on our risk profile. I have a fairly high risk tolerance, so it is fine for me to consider companies that ride the roller coaster of the market’s highs and lows. My wife, on the other hand, gets nervous when she hears about declines that may affect her portfolio, so to sleep comfortably at night she needs to stay with positions that smooth out these ups and downs.
The bottom line is to understand where your risk tolerance lies – it is different for everyone, and there is no “correct” answer outside the one you assign to yourself. Then look for companies and funds that correspond to that risk tolerance. If you are unsure where your tolerance lies then it is best to assume that it is low until you go through an actual recession, then reconsider.
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