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Which asset class is the most risky?

In the financial world, there are varying interpretations and definitions of risk, with scholars, market practitioners and investors all viewing risk from their own perspective. Nothing wrong with that, but it is important for investors to understand the misconception about risk and look towards getting a better understanding of how different types of risks impact different asset classes.

Put simply, the major concern an investor has is to quantify and understand the level of risk being undertaken when putting his/her hard fought earnings to work, and the likelihood/probability of the risk of losing those monies (in whole or part of) throughout the duration of the investment.

One of the key factors that an investor should know about different types of risks between the varying asset classes is the distinction between market risk and issuer-specific risk.

As we all know, financial markets are influenced by an endless number of market forces which interact and combine to create millions of daily transactions. The forces of demand and supply will determine whether a security or asset class will go up or down in value, and this will ultimately be determined by the market's overall stance on current valuations vis a vis the market outlook. This is what we term as market risk; the risk that the value of an asset class would go up or down over a specific period of time, based on the regions or global economic outlook.

Issuer specific risk can be quantified through a fundamental assessment of the financial strength of a bond issuer for example, or of an equity. Credit Ratings are a key tool used by investors and asset managers alike to compare - by using a common rating scale - the varying degrees of risk of a bond issuer. A BBB rating on a bond indicates that the risk of the bond issuer defaulting on its financial obligations is larger than the risk of default of an AA rated bond. Likewise, financial models can determine and forecast the sanity and robustness of cash flows between two equities for example, and the varying degrees of risk between the two.

So going back to the title, which asset class is the riskiest? Bond or equities? Investment Grade bonds or Emerging Market bonds? Investment Grade bonds or equities? Cash holdings or Emerging Market bonds?

Well it depends on various factors really. Statistically, volatility (a risk measure of the swings in price movements of an asset) will indicate that cash is the less risky whilst high yield, emerging market bonds and equities are on the riskier spectrum. However, everything needs to be seen and put into context. Risk is all relative and is dynamic. The risk of an asset class changes daily, and the market risk for it is based on the valuation of that asset class given the market outlook for that particular class.

Which is the riskiest, cash or equities? Right now, given the health of the global economy, I would say cash, not because there is the risk of losing money by keeping it idle, but there is an even greater risk called opportunity cost on missing out on the potential returns of equities.

Which is the riskiest asset class, investment grade bonds or emerging market bonds? If you had to dissect the overall credit quality of both asset classes, it comes as no surprise that investment grade bond issuers have a lower possibility of default in comparison to their emerging market counterparts. However, with investment grade bonds trading at such tight valuations, and with credit metrics of emerging market issuers on the rise, from a markets perspective, emerging markets still offers value. In my opinion, investment grade bonds, at this juncture, have got nowhere else to go.

Which is the riskiest asset class, investment grade bonds or equities? If risk is quantified by volatility, statistics indicate that equities have been the more volatile asset class. However, from a market, valuation and fundamental perspective, in my opinion, the current downside market risk (in the short to medium term) seems to be skewed more towards investment grade bonds than it is for equities.

This does not mean that a portfolio should not have any exposure to investment grade bonds and be fully invested in equities; far from that. I am one to believe that a portfolio should consist of varying assets and asset classes for risk diversification purposes. What I am saying is that exposures to asset classes in investment portfolios should not be static but challenged and tweaked to reflect the overall outlook for those individual assets and asset classes within the context of the outlook for the global economy.

 

This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. 

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