Types of Investment Risk: Dilution
Published on June 14, 2013
We are in the middle of a series breaking down the various types of investment risks. You can read the introduction here. We are posting one article covering one risk each weekday until the series is complete.
Yesterday we covered Market/Socionomic, and today we are covering...
Risk #5: Dilution
Description: This risk is conceptually similar to inflation risk, but is generally used in the context of equity ownership rather than currencies. Dilution risk refers to the potential of a company to issue more stock, thereby diluting the percentage ownership of all of the existing shareholders. This can come about through employer/director stock options that reward the employees and management of a company, or through an expansion of stock to attempt raise additional capital. In either case, the new stock issued reduces proportionally the ownership of the existing shareholders.
Primarily Applies to... Equities or equity-related investments (private or public) are the primary victims of this risk as management will issue additional stock on occasion that dilutes the existing shareholders. REITs or funds that remain open for an extended period could be subject to this risk as well.
Real World Examples: In the financial crisis and Great Recession of 2008, many of the largest banks were forced to sell stock to the government in order to raise equity. The existing shareholders were diluted with the new stock.
Extreme Avoidancee Measures: Don't invest in stock, equity related investments, or unsecured bonds.
Potential Mitigations: Know the compensation programs of the companies into which you invest. Avoid companies that have a track record of dilution or need to issue new shares to raise capital. Seek out companies that have owners invested such that new dilutions would harm the top management, and would thus be avoided if possible. Make investments that do not allow for dilution without shareholder approval.
Stay tuned, tomorrow's highlighted risk is: Environmental.