Invest with your head, not your heart: managing investment risk
Risk is the possibility of loss. Sometimes the loss is trivial, while at other times it may cause major personal and financial hardship. No investment is completely risk-free, but some investments carry more risk than others.
All investments carry with them some degree of risk, and may arise from many sources. Stocks, bonds, mutual funds and exchange-traded funds can lose value, even all their value, if market conditions sour. Even conservative, insured investments, such as certificates of deposit issued by a bank or credit union, come with inflation risk. And some investments carry more risk than others – generally, the higher the expected return, the greater the risk.
By better understanding the nature of risk, and taking steps to manage those risks, you put yourself in a better position to meet your financial goals.
Classification of risk
What is risk? Risk is the danger that unwanted events may happen or that developments go in an unintended direction. Investment risk is the possibility that you might lose some or all your original investment, or that the investment may not perform as expected. Generally, the higher the chance of a loss occurring, the higher the investment risk and the higher the expected returns should be.
When you invest, you are exposed to different types of risk. These key risks include:
- Market risk is the risk that market prices (e.g. interest rates, foreign exchange, stock and option prices) change in an unfavourable way or that a market does not function as desired. Market risk is caused by the universe of all economic agents in the relevant markets.
- Credit risk is the risk that an issuer of a debt instrument may not be able to make the capital repayment at the end of the period of investment or that they may default on interest payments.
- Liquidity risk is the risk that you may not be able to sell the investment at short notice due to the illiquid nature of an investment. An example of this would be direct property.
- Operational risk is the risk of loss due to inadequate monitoring systems, management failure, defective controls, fraud, and/or human errors. Operational risk is of greater concern to portfolios that incorporate derivative securities - derivatives are highly levered instruments due to the low equity investment required to control them, where small changes in the value of the derivative contract can substantially influence return on investment.
- Specific risk, also referred to as unsystematic risk, is tied directly to the performance of a particularly security. An example of specific risk is the risk of a company declaring bankruptcy, which would negatively affect the price of its common stock.
- Inflation risk is the possibility that the value of your assets or income will decrease as inflation shrinks the purchasing power of your money. Inflation causes the value to decrease whether the money is invested or not, so it is a risk that can erode the value of a portfolio year after year. Significant amounts of cash left in a cash account with a low interest rate for long periods would be an example of inflationary risk to a portfolio.
Outside of these core financial risks are a plethora of other risks such as country risk, systemic risk, behavioural risk and governance risk for instance. These risks however are more aligned with big-business and corporate strategy.
Why have any risk in your portfolio?
We define investments in two broad categories: growth assets and defensive assets. Growth assets are usually shares or property. These investments generally have the potential to earn higher returns but carry higher risk over the short term. The rate of return of the investment may vary and the value of the investment may be more volatile.
Defensive assets on the other hand, provide little chance of capital loss but generally earn a lower return. These types of assets include cash and fixed interest, and returns are less likely to fluctuate in the short term.
When you invest, you expect to get a return on your money. You're probably also hoping you'll be able to buy more with your money in the future than you can today. If so, your return needs to be higher than the rate of inflation. As such, the amount of risk and the kind of assets you invest in, can affect your investment outcomes:
- No risk: you can hold on to defensive assets, such as cash, and eliminate risk but your money will be going backwards because inflation will increase the cost of goods and services.
- Low risk: if you choose a low-risk investment, such as a bank account or government bond when interest rates are low, your returns may not be much higher than the rate of inflation, so you'll probably be standing still financially.
- Higher risk: if you want your money to grow, you'll need to take on more risk. This means putting some money into growth assets like shares and property. You will usually get higher returns, on average, over the longer term, but the trade-off is that they may lose value over the shorter term.
You cannot eliminate investment risk completely, but creating a risk management strategy can help to reduce your risk.
Every investor should have a risk management framework aligned to their investment objectives and time horizon. Risk management is important because it can reduce or augment risk depending on your goals. It is a two-step process of determining what risks exist in an investment and then handling those risks in a way best-suited to your investments.
Developing an effective framework requires measuring, monitoring and managing exposures to both economic and fundamental drivers of risk and return across asset classes to avoid overexposures to any one risk factor. Your risk management framework should also enable dealing with risk during both normal times and extreme events. Your financial adviser can help you to set-up an effective risk management strategy.
There are many things you can and should do to manage the risks associated with investments. These include, but of course, are not limited to:
- Making sure your investment strategy meets your investment objectives and financial situation.
- Understanding the nature of the investment you are making.
- Investing for at least the suggested minimum investment timeframe for an investment.
- Regularly reviewing your investment considering any changing objectives or financial situation.
There are also two basic investment strategies which can help manage your risk
- Asset allocation: by including different asset classes in your portfolio (for example stocks, bond, real estate and cash), you increase the probability that some of your investments will provide satisfactory returns, even if others are flat or losing value.
- Diversification: when you diversify, you divide the money you’ve allocated to an asset class, such as stock, among various categories of investments that belong to that asset class. Diversification, with its emphasis on variety, allows you to spread your assets around.
Hedging (buying a security to offset a potential loss on another investment) can also provide an additional way to manage risk. However, hedging typically involves speculative, higher risk activity such as short selling (buying or selling securities you do not own) or investing in illiquid securities.
Your financial adviser can help you to create a portfolio which reflects both your short-term needs and longer-term financial goals. They will also work with you to determine your attitude to risk, and will consider issues such as investment time horizon and wealth level to establish your risk tolerance.
Disclaimer: The information contained in this communication is general in nature and does not take into account your objectives, financial situation or needs. You should consider whether it is appropriate for your personal circumstances prior to making any investment decision.