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Understanding Risk when Investing in Stocks
Course Section 2 - Lesson 3
The Financial Crisis of 2008
On September 15, 2008, Lehman Brothers, the fourth-largest investment bank in the United States, failed due to large bets they had made in the US mortgage markets. The bank's failure triggered the forced selling of billions of dollars of securities as the financial sector scrambled to reduce its leverage and avoid the same fate as Lehman.
Banks and hedge funds dug through their portfolios, looking for any assets they could sell to raise cash. This forced selling had a dramatic effect on the price of all financial assets. Two weeks after the selling frenzy began, the S&P 500 (a Large Cap US Stock index) was down over 10%. After three weeks it was down nearly 30%. After nearly six months of extreme volatility in the financial markets, the S&P 500 bottomed out after losing roughly half its value.
Streaming Video Overtakes Movie Rental Companies
In the mid-2000s, video streaming services started popping up on the internet, youTube in 2005, then Amazon's Unbox in 2006, Netflix in 2007, followed by Hulu in 2008. At first, consumers and corporations alike thought the internet was a place for cat videos and b-movies, not for a medium for serious content consumption. That opinion changed quickly as consumers discovered how easily they could summon their favorite shows and movies.
While many industries were and continue to be affected by the sudden shift in consumer preferences, one of the earliest and hardest hit industries was the movie rental industry. In the '90s and early '00s three major competitors fought for rental market share: Movie Gallery, Hollywood Video, and Blockbuster. These were not small operations; combined, the three chains had over 15,000 locations in the US. Just five years after youTube's launch, all three chains had gone bankrupt.
BP Deepwater Horizon's Disaster
In the afternoon of April 20, 2010, an explosion at a British Petroleum offshore drilling rig killed 11 people and triggered an environmental disaster that would eventually release 5 million barrels of oil into the Gulf of Mexico. For three months, BP fought to stem the flowing oil at the damaged well before finally getting it under control. The disaster was the largest marine oil spill in history.
British Petroleum was found guilty of gross negligence as a result of the spill. The company was forced to pay for clean-up efforts and fines that totaled nearly $20 billion. In total, the disaster cost the company around $65 billion. More painful for investors, however, was seeing the value of the company fall from $185 billion before the disaster to less than $85 billion in just nine weeks, erasing 55% of investors' money.
Investors Always Face Risk
As investors, we take risks. Part of the reason investors earn the returns they do is that they are willing to take on risks that others are not. All risks are not created equal, however. As you invest your financial resources into stocks with an unknown future, it's important to understand exactly what risks you are taking. The three stories above represent three types of risk that investors face. They are also three of the most difficult to protect against.
In this lesson, I want to review three types of risk specifically, which we will call market risk, industry-specific risk, and company-specific risk.
Market Risk is the risk that the price of all assets will fall, with the decline in prices relatively consistent across all assets of a similar type. A broad-based market decline, like that which we witnessed in 2008, exemplifies market risk. Investors had no place to hide. It didn't matter how much research they did into their holdings or how well they picked the stocks in their portfolio. Nearly every single stock fell during this period.
2008 was a dramatic example of market risk. But as investors, we don't have to look back more than a decade to find examples of market risk affecting portfolios. As I write this, we are just a year out from the beginning of the Covid-19 pandemic, which triggered a 30% sell-off in stocks globally.
Market risk isn't just felt after a market decline. Right now, many investors are worried about how richly priced all stocks currently are—fearing that a decline in investor sentiment may trigger a market sell-off. (As of the date of writing, the market was trading 37x its average earnings over the last ten years, this is among the most expensive valuations of the last 150 years.)
It is incredibly challenging for investors to protect against market risk. The only way to reduce market risk is by taking the risk off the table completely. In effect, for most small investors, this would mean selling at least some portion of your investment portfolio and holding cash instead. This solution presents risks of its own. Namely, the fact that being uninvested for long periods can lead to sub-par investment results.
Certain events can hit specific industries particularly hard while seeming to have little to no effect on others. We refer to this type of risk as industry-specific risk. A shining example of industry-specific risk is the movie rental industry's downfall during the emergence of streaming video services.
While industry-specific risk can seem inevitable in hindsight, it is hard to label in real-time. And as we saw with Blockbuster and its peers, industry-specific risks can decimate an industry in the blink of an eye. Similar to industry-specific risks are company-specific risks.
BP's Deep Horizon disaster is a perfect example of company-specific risk. The disaster was devastating to BP shareholders, decimating the value of their investments. Despite this, other companies and stocks fared perfectly fine; the market did drop a bit during the disaster, a few percentage points, but it recovered quickly after the incident was contained. Further, while concerns over increased legislation did spill over other companies in the oil industry, share price declines were primarily concentrated in BP shares.
Company-specific risk, like industry-specific risk, is inherently unpredictable. If it were predictable, investors would simply sell stricken stocks before the risk struck. Investments that you make will succumb to both industry & company-specific risk factors.
But there is a way to protect yourself against these types of risk; by investing in multiple companies across multiple industries. By not keeping all of your eggs in one basket, so to speak, you limit the degree to which these two risk factors can damage your portfolio. Because we can mitigate these risks by spreading our investment bets, we refer to them as diversifiable risks.
In the next lesson, we are going to talk more about exactly how we achieve the necessary level of diversification to protect our portfolios.