Risk - The Darker Side of Investing

Returns and risks of investing – a return cannot be earned without taking some risk.  But investors sometimes forget the two are inextricably linked.  Astute investors understand how much risk to take and don’t exceed that level while professional managers see managing risk effectively is as important as generating returns.

Lets look at Investment risk and its many faces. The understanding that your investment may not perform as expected should be driven by your individual risk tolerance and time horizon.  One of the fundamental ways to manage investment risk is by diversifying across multiple assets or securities to minimise volatility (risk).  Investing across asset classes will help minimise the risk in your portfolio.  However, you should be aware of all potential investment risks, particularly when making an initial investment decision. So, what are the main types of risks and how can they be managed?

First, Liquidity risk. This is the risk that you won’t be able to get your money back without taking a significant investment hit.  For a home owner, the relative illiquidity of a property and mortgage means that selling the property and receiving a fair price is likely to be a time consuming exercise.  Most listed or managed investments are relatively liquid as typically shares or units can be redeemed quickly, efficiently and inexpensively for cash.  Unlike the family home you can redeem part of the investment for cash quickly and easily.

Emotional risk is a key vital ingredient in investment markets, which are dominated by greed and fear.  An amateur investor may easily become over-confident or under-confident, trying to time the selling or buying of a stock by trading ‘on momentum’ without the advantage of a rigorous systematic investment process. Fear and greed fuel many investment decisions, most decisions made on the back of these terrible twins end in tears.

Credit risk on debt securities such as bonds comes in degrees.  This is another way of saying that a bond issuer may fail to repay interest and principal in a timely manner (also known as default risk). Manage this by holding a number of different issuers (Government, semi-government and corporate) with a good well researched investment grade credit rating (BBB- and above).

Currency risk, currency fluctuations can be substantial.  For investors, a rise in the NZ$ reduces returns (in NZ$ terms).  By contrast, a falling or softening NZ$ boosts the total return. You can hedge the portfolio’s foreign currency exposure back into NZ$.  This may be non-tactical (passive), or on a tactical (active) basis.

Market or Industry risk The possibility that a group of securities in a single industry will decline in price.  Diversifying across sectors or industries can help manage this type of risk. The finance company arena is an excellent  example of this type of risk in action.

Inflation risk erodes the purchasing power of an asset.  Even with modest inflation of 3% pa, a $50,000 cash investment over 25 years will be worth just $23,348 in today’s terms – its ‘real’ value.  Be aware of course taxation also needs to be figured in your assessment.

Political risk as with currency, political changes can also have an impact on investments.  For instance, a change in economic policy or trade restrictions can lead to market declines and affect returns from  investments.  Political risk can be difficult to avoid - those with global research resources are better placed to judge such risks.

Conclusion

Investors will inevitably find that investment risk – it its many guises – can hamper their portfolio returns.  A good strategy is to become familiar with such risks or delegate to a professional manager.  Your CFP certified financial adviser is well placed to discuss investment risk with you in more detail.