Risk: Balance risk and reward to optimize performance

 

The key is to balance risk and return in a way that makes sense in light of your investment goals. But to control risk, you have to understand it. The following describes the main types of investment risk and the ways risk is measured:

 

·        Event risk: Events such as war, earthquakes and government actions all can change the political or economic landscape in a country or region. 

 

·        Capital formation risk: A company's capital structure sets an order of payment priority. Uncle Sam gets paid first (taxes), and banks. Then follow, in sequence, commercial-paper holders; bond holders; preferred-stock holders; and equity holders.   That means that if the company founders, stock holders are the last to get their money out.

 

All types of investments are affected by capital formation and event risk. Other types of risks affect just stocks or just bonds.

 

Risk in the stock market is measured in two main ways: beta and R².

             

·        Beta: This measures the stock's volatility—how far and fast the stock rises and falls—in relation to the Standard & Poor's 500 Stock Index. The S&P 500 has a beta of 1. Stocks with a beta higher than 1 are more volatile than the index, while those with a beta lower than 1 are less volatile.

 

·        R²: While beta measures how a stock performs relative to the market, it doesn't tell how that performance tends to correlate with the market's ups and downs. That is what R² measures. For the sake of diversification, you don't want your investments correlating closely with the market as a whole. 

 

Bonds are subject to three main types of risk: credit quality; interest rate and volatility:

 

·        Credit quality: This relates to your assurance of receiving timely payments of principal and interest. Bonds are rated by services such as Moody's Investors Service, Standard and Poor's and Fitch Investors Service. Ratings range from AAA (default is extremely unlikely) to D (in default).

 

·        Interest rate: The value of bond portfolios is sensitive to changes in interest rates; bond prices tend to move in the opposite direction of interest rates. The measure of this sensitivity is duration, or the bond's term to maturity. Longer-term bonds are more volatile than short-term bonds.

 

·        Volatility: This measures the portfolio's quarterly standard deviation of returns against some benchmark, or index.

 

When evaluating the performance of an investment portfolio, you'll always look at returns. However, don't forget to look at much risk went into producing those returns. Two managers can produce similar returns with widely differing levels of risk. They might look the same until the market declines—then you'll see the steeper downside of more risk exposure.

 

Karpus Investment Management minimizes portfolio risk through the highly effective strategy of extensivediversification, not only among asset classes but also among asset categories and investment styles. This protects portfolios from vulnerability to events that affect the value of particular holdings. In addition, we buy only investment-grade securities and we keep bonds at an average duration of roughly five years. Our strong returns have been noted throughout our industry. The other side of the equation is equally important though less dramatic: low risk.