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Types of Investment Risk: Counterparty Risk

We are at the end of a series breaking down the various types of investment risks. You can read the introduction here. We posted one article covering one risk each weekday until today, when we will conclude the series.

Yesterday we covered Operator/Management Risk, and today we are covering...

Risk #15: Counterparty Risk

ChainsDescription: When an investment depends on the solvency or financial backing of a third party to either control funds or complete a transaction, this investment is subject to counterparty risk. If anything happens to the party that is either in the middle of the transaction or on the other end of the transaction, it could cause loss to the investment or the failure for the investment to operate as intended.

Primarily Applies to... Any investment for which the collateral is liquid and managed by a third party, or that depends upon a third party to post payment based on an investment result or insured triggering event. Hedge funds, derivatives, insurance contracts, managed futures--even closing on real estate and depending on an escrow company involves some form of counterparty risk.

Real World Examples: AIG became insolvent almost overnight (and would have gone bankrupt had it not been for the massive government bailout) when defaults started to soar because AIG made insurance promises that were intended to pay out in the event of those defaults. If you were insured with AIG you took the risk that they would be able to make good on those insurance promises. Every time you take out insurance for your home, car, life, etc., you are depending on the insurance company to be able to pay out if an insured event is triggered.

Extreme Avoidance Measures: Hold cash in a mattress and do not make any investments, take out any insurance, or complete any transactions that involve reliance on a third-party.

Potential Mitigations: Other than outright avoidance, diversification is the only way to potentially mitigate counterparty risk. Diversify into investments that do not necessarily involve a counterparty or that have truly separate counterparties to avoid overconcentration in a single counterparty that could fail. Avoid counterparties that are not sufficiently well-known, established, reinsured, bonded, or government backed.

Types of Investment Risk: Conclusion

Every investment you make (or don't) involves taking on risk. Even if you decide to stay in cash rather than deploy capital, you have not avoided investing at all; you have simply decided to remain invested in government-backed zero-coupon bonds (cash) or government-insured interest bearing bank deposits. At all times, you are forced to decide between risking a loss of principal (by investing in stocks, bonds, real estate, non government-backed assets) or a loss of buying power (by investing in cash or government backed securities).

Rather than be paralyzed by risk, we have the opportunity to understand and use risk to our advantage. Markets tend to overreact to risk and/or ignore it altogether. Markets are far from perfectly efficient partly because everyone values risk differently, and human nature tends to swing from one end of the spectrum (risk aversion and fear) to the other (careless disregard for risk and greed). In extreme cases, the markets may be altogether ignorant of certain risks, or lulled into a sense of complacency that blinds the broader market to risks that are rising. The financial and housing crises in 2008 and beyond are great examples of the latter ignorance of and/or disregard for risk on a grand scale. It is precisely in these market overreactions that outstanding buying and selling opportunities are born.

Once an investor embraces the fact that they always face risk, they can more appropriately identify and balance the types and levels of risks they are willing to take. Understanding risk is one of the greatest keys to protecting and growing your wealth and it provides incredible insight into investment opportunities created by the undervaluation, overvaluation, or ignorance of risk by other investors.