Understanding Risk

16.01.13

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One of the greatest issues which investors face is understanding risk. So many investors say they do not want to take any risk, or only a very low level, but in most cases they are o

One of the greatest issues which investors face is understanding risk. So many investors say they do not want to take any risk, or only a very low level, but in most cases they are only worried about how volatile an asset could be. They fail to consider other types of risk that could affect their capital and which can be planned for.

With regards investment risk, risk and reward go hand in hand and it is generally not possible to have one without the other. This does not stop investors desiring and looking for the best rewards while at the same time being determined to take on as little risk as possible. What often happens is that in their bid to keep risk to a minimum, they miss out on the potential for higher rewards. Rewards that would, for example, help improve their financial security through retirement. Rewards they could have earned at lower levels of risk than they expected if they had the right advice and strategies.

Risk does not necessarily have to be viewed as a negative concept, but rather as an inherent part of higher reward. First, though, let us look at the types of risk you need to be aware of.

Capital risk: The risk that prices will fall and your original investment will decline in value.

Market risk: The possibility that market volatility will negatively effect your investments.

Credit risk: The risk that a borrower (in the case of bonds) will default.

Institutional risk: The risk that the financial institution managing your money, be it an investment house, insurance company or bank, will fail.

Currency risk: The possibility of loss by not considering your spending currency.

Liquidity risk: The possibility that you may not be able to sell your assets when you need the money, or that you will have to sell in a depressed market.

Inflation risk: The chance that your capital will decline in value as rising prices shrink the value of the currency it is invested in.

Many savers and investors only consider whether they will lose money on their investments through price declines. However you must also consider whether you will make ?real? returns above inflation. If not, you are effectively losing money. It has been very hard to achieve real returns with cash over recent years, and lower risk assets like government bonds do not offer much protection against inflation either.

To aim to outpace inflation, you need to include assets higher up the risk scale like high yield bonds and equities in your portfolio. Long-term, equities have historically beaten inflation by a wide margin.

Very low risk investments may protect you from market risk but will expose you to inflation risk. Keeping savings in cash also exposes you to institutional risk. You need to compare risk against risk (there is no such thing as ?zero risk?) and establish which one represents the greatest long-term threat. Then work to suppress it by accepting the lesser risks. In this scenario, risk is not a negative concept.

The risk of doing nothing: Often, the greatest risk for investors, particularly those who rely on their savings in retirement, is doing nothing. Leaving all your savings on deposit and withdrawing the interest as income, completely exposes the capital value to inflation. The buying power of your money will be reduced over time.

When planning your investments, investment risk obviously needs to be given importance, but so does the risk of missing out on potentially rewarding opportunities.

Combating risk

Milton Friedman, the celebrated economist, famously said ?there is no such thing as a free lunch?. In other words, you cannot have rewards without risk. Another leading economist, Peter Bernstein, countered this with: ?Diversification is the nearest an investor or business manager can ever come to a free lunch.?

The central idea of diversification is that almost all types of investment risk can be mitigated if you choose not to expose all your capital to any individual situation.

Investment assets behave in different ways and respond to news, economic cycles, geopolitical situations and sentiment in varying degrees. By including a variety of asset classes in your portfolio, the risk is likely to be much lower than if you put all your money in one type of investment. Diversification is as much common sense as it is science. It takes a middle road through the highs and lows of market performance, giving your money the opportunity to grow over time and with fewer fluctuations along the way.

Risk is part and parcel of investing and need not be feared as much as it is. It is an essential component in earning rewards. You should take expert advice from a wealth management firm like Blevins Franks on suitable strategies for your specific, personal, circumstances, time horizon and objectives.

20th November 2012

Tax rates, scope and reliefs may change. Any statements concerning taxation are based upon our understanding of current taxation laws and practices which are subject to change. Tax information has been summarised; individuals should seek personalised advice.

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