Many people, when they hear about financial ‘risk’, think automatically about the chance of being defrauded and the horrible prospect of not getting all their money back.
Risk scares people, but there’s much more to it than that. Risk can also be a very good thing as it leads to higher returns in the long run when properly managed by a professional financial advisor.
“The biggest risk is not taking any risk.” (Mark Zuckerberg)
So, what is risk, exactly?
Investment risk can be defined as the probability of loss relative to the expected return on any investment. It’s a measure of the level of uncertainty of achieving the returns expected by an investor.
Systematic and unsystematic risk
Investment risk can either be systematic or unsystematic. Systematic risk, or market risk, is the uncertainty that affects the entire market due to external factors. Unsystematic risk is uncertainty that emerges out of controlled variables that are specific to one industry or company.
Common forms of systematic risk include:
- Interest rate risk is caused by the changes in interest rates and the effect on interest-bearing investments such as bonds and cash instruments.
- Inflation risk is caused by the rise in the cost of production of goods and services.
- Currency risk, or exchange rate risk, is caused by changes in the prices of commodities, interest rates, inflation and politics.
Common forms of unsystematic risk include:
- Business risk is inherent in a company or industry and is caused by factors such as a rise in competition, the development of substitute products or technological change.
- Financial risk, or leveraged risk, is caused by the change in the capital structure of a company.
Why be risky?
When it comes to selecting your investment, you need to be aware of the amount of time you have in the market and the risk associated with each of the asset classes.
- Cash is suitable if you have a very short-term outlook (1 to 2 years) as it doesn’t bear much risk but will lose value due to inflation.
- Bonds, which pay a fixed interest amount at various intervals, are good for medium-term investments (1 to 3 years) and carry a low to moderate amount of risk.
- Property, which provides a rental income as well as capital growth, is suitable if you have a longer-term outlook (over 7 years). It has more risk than bonds, but less than equities.
- Equity, which provides dividend income and capital growth, is the most volatile and risky asset class but produces the highest investment returns in the long run, making it best for long-term investors (at least 5 years).
Risk management and diversification
Understanding the relationship between asset classes is key to reducing risk in an investment portfolio. Investments within each asset class move in the same direction during investment cycles. This differs from the way asset classes behave when compared to each other.
Investment diversification is all about combining assets classes which exhibit low or negative correlations and thus move in opposing directions during an investment cycle. It also includes investing in different geographic regions, and in different industries. Diversification minimizes systematic and unsystematic risk, smooths out volatility, and assists to provide consistent returns from a portfolio of investments.
A personal relationship with risk
As well as having insight into asset classes, time frames and the benefits of diversification, you need to consider your risk profile, which comprises:
- Risk required: the amount of risk needed to achieve your investment goals. For example, if you have a short-term investment horizon and need a significant return, you may need to assume a high level of risk by investing in something volatile like currency.
- Risk capacity: how much financial risk you can afford to take without compromising your goals. A young investor with a long-term investment horizon would have a far higher risk capacity than an older investor with poor cash flow and increasing expenses.
- Risk tolerance: your emotional willingness to take on risk. Would you be able to sleep at night if your high equity retirement portfolio plummeted by 25%?
A happy mix
Your risk profile will determine whether you’re a conservative, moderate or aggressive investor.
At the risk of generalizing, conservative investors are more concerned with preserving their capital and seek to avoid volatility and fluctuations in the value of their capital. A typical portfolio would comprise 50% bonds, 30% cash and 20% equities.
Moderate investors usually want to preserve and grow their capital, while perhaps earning some income too. Moderate portfolios are typically less volatile than the market and may comprise 55% equities, 35% bonds and 10% cash.
Aggressive investors want to grow their capital and are prepared to take on the necessary level of risk. They invest for the long term and accept that the value of their investments will fluctuate over the shorter term. An aggressive portfolio may comprise 85% equities, 10% bonds and 5% cash.
Have your cake and eat it
Investing with specific goals and timeframes means you can be all three types of investor. You might invest aggressively towards your retirement (assuming you’re relatively young), moderately towards your children’s education, and conservatively towards your short-term emergency fund.
The bottom-line
Risk – like death and taxes – can never be entirely avoided! But by better understanding both the nature of risk and your risk profile and by taking steps to manage those risks, you put yourself in a far better position to meet your financial goals. Got any questions about risk? Our door is always open.
Disclaimer – *The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.
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