Equity Investments

• When you buy stock, you are buying a fractional ownership of a company. Because you are an owner, the board of directors and managers of the company operate on your behalf. As an owner, your payback is in the form of dividends and appreciation in the value of your ownership share, or stock price, as the company grows and prospers. If the company falters and fails, it must pay its creditors out of any liquidation proceeds. In these situations, there is normally little or nothing left for the owners.
  
  

Debt Investments

• When a bank makes a mortgage, it requires a 20 percent down payment and retains liquidation rights to the house until the mortgage is paid off. Assuming the house can be sold for at least its purchase price, the bank loan is protected by 120 percent collateral. Combine this collateral coverage with a borrower who has a good record of paying off debts, and you have a near-perfect loan -- unless the housing market collapses more than 20 percent. This is the basic risk consideration associated with loans.
  
  

Managing Equity Risk

• Risk managers use tools to manage the risk in their equity portfolios. Among these tools are diversification of types of equity holdings, hedging through the use of options and threshold values that trigger liquidation. In managing a portfolio, you never want to have all your investments in the same industry or type of company. Economic conditions affect certain industries more than others, so your investment portfolio is stronger if you diversify over cyclical and countercyclical industries and companies that sell, manufacture, service, import or distribute. Hedging places a negative bet on a purchased asset just in case the asset drops in value.
  
  

Managing Loan Risk

• When buying bonds, credit and collateral are just as important as they are to a bank that's making mortgages. Investment-grade bonds are rated from the highest credit at AAA, successively lower to AA, A and BBB with lower ratings considered speculative or junk bonds. The highest collateralized bonds are called first-mortgage bonds and they carry senior call on the assets of the issuing corporation. Debentures have rights to the proceeds of liquidation after the mortgage bonds, and subordinated debentures are the lowest collateralized bonds.