An Introduction to Risk

Risk can be measured by how volatile an investment is. The volatility of an investment is a measure of how quickly the returns on your investments can change. The more quickly the returns on an asset can change, the riskier it is.

Risk is also linked to timing. If you need to precisely time an investment, it is generally riskier. But if the timing has no real effect on whether or not your investment will produce good returns, then the investment is generally less risky.

So let’s take a look at an investment. Say you want to invest $1000 of your hard-earned money into a term deposit with one of the big four Australian banks. You want to invest for 3 to 6 months. The general return now is around 2-3%. These rates don’t change fast, so timing isn’t too important. And the big banks being large institutions you are very likely to get your $1000 back, with the interest payments.

There is a little risk with term deposits, both with losing your capital’s value or having to time when you invest.

On the other hand, let’s say you want to invest $1000 into Genesis Energy shares for 3 to 6 months. There is no way of knowing what your returns will be upfront. So you don’t know how much you will receive back when you go to sell your shares. It could be anywhere between $800 to $1200. No one can tell you for certain how much it will be. So there is a risk in the return on your investment. Secondly, the share price can go up or down as much as several per cent in any given day. Then again, it could take years to increase by several per cent. So timing is much more important.

There is a greater risk with investing in shares, both with losing your capital’s value, and timing has a greater effect.

The primary goal of any investment portfolio is to diversify and maximize your returns while at the same time minimizing your risk. Two risks that are not often taken into account is inflation risk and the risk of investing itself.

1. Inflation risk

Many investors can understand the concept of inflation risk. Inflation is the rate at which prices of things increases. Have you noticed that over the years the price of petrol or grocery has become more expensive? This is inflation. Your money’s buying power is falling, so you need more money to buy the same things.

You need the assets in your portfolio to grow faster than inflation. Otherwise, in real terms, the value of your money won’t be growing, and in rare cases can actually decrease in value. That is not to say that your portfolio’s monetary figure does not increase; rather, the buying power of your money isn’t increasing.

While inflation is minimal today at around 1-2%, there have been periods in our history where it has been much higher. We are currently experiencing a relatively low level of inflation. And we won’t know what inflation will look like in five to ten years.

The second risk that is not often talked about is the risk of investing itself.

2. Investing Risk

Yes, investing is a risk.  Let me explain. Your goal is to maximize your return and minimize your risk.  The concept of investment risk is when you miss out on the chance to maximize your return by investing in a certain high return investment because you have already invested your money in another asset which may be performing worse.

When you invest, you are generally locking in your money for a period of time in a given investment vehicle. And changing between can incur some fees or transaction costs, such as real estate fees when selling an investment property.

well-diversified portfolio will help you against investment risk. At any given time, one of the main investment classes, shares, property, bonds and cash, will be performing superiority compare to the others. Therefore to decrease investment risk, you should make sure that you have stakes in all three of these investment classes.

Keep in mind that while you need to spend time determining the right share or property to invest in, it is consistently shown that the diversification over asset class in which you are invested protects you from investment risk.

No matter how many stocks you have invested in if the stock market crashes, all your stocks are likely to fall in value, but that would not necessarily mean a fall in the housing market.

3. Timing risk

Timing risk is the risk that you buy an investment at the right time or worse the wrong time. Timing is important for certain investment classes, and less so for others. The risk comes from buying at the wrong time. It might be buying before a market turn. But it can also be selling at the wrong time. For instance, you might decide to sell an asset because the value has declined for several months. Only to find out later that if you had held, the value would have gone up again.

For shares and index funds, the risk of timing can be minimized by the use of dollar-cost averaging.  More about that later.

What about Investing Overseas? Let’s face it; New Zealand is a small country not small in size but small in population. There are many cities worldwide with more people than the entire New Zealand population, London, New York, and Tokyo. This leads me to another risk that needs to be talked about, which is an economic risk.

4. Economic Risk

Economic risk is the risk which comes from investing all your money in one economy. Even if your investment portfolio is well-diversified over different investment classes, you will still be exposed to economic risk if they are all in the same economy.

Taking about economic risk a step further, we are all exposed already to economic risk. Even if we don’t invest, that is because we are tied to the New Zealand economy through our salary and wages and inflation. Our own success is tied to New Zealand’s success.

Let’s explore some of the economic risks New Zealand faces.  New Zealand has several disadvantages compared to other countries economy.

  • We are geographically isolated and often left off the map.
  • We have a small population base.
  • Our economy is highly dependent on primary industry, such as farming and forestry.
  • And in the future, our ageing population will have a large burden on our government

So if you invest for the long term, for longer than 5 years, then investing overseas should be considered. This will help diversify your investment portfolio to another level.

This is not to say that there is an economy without risk. In fact, many other economies face the same risks as New Zealand, especially the burden of ageing populations. But investing in several economies will shield you against one of those economy tanking.

Economic risk is also when other economies are outperforming your own economy—this causes you to miss out on potentially higher returns.

5. Currency Risk

One thing to remember when investing overseas is that you will be exposing yourself to currency risk. When the New Zealand dollar weakens, it talks more New Zealand dollars to buy imports, such as cars and goods. This affects consumers and affects company and businesses as their products or machinery used to create products have become more expensive.

There is no real way to know exactly which way the currency exchange will go. Even experts don’t fully understand it. There are theories of cycles and waves such as Elliot waves that currency traders use to predict the future. But most won’t be much above 50-50 in their pericarditis power.

Still, even being slightly higher than 50-50 can become profitable if you are a disciplined currency trader.

The currency risk looks like this. You invest $1000 NZD in overseas shares. Take the United States as an example, at an exchange rate of 0.50. Your investment is worth $500 USD.

Your shares have increased by 10% and are now worth $550 USD, however, the exchange rate has also risen to 0.60.  So converting back to NZ dollars your investment is worth $917.Currency risk can work both ways if the exchange rate had fallen to 0.40, then your $550 USD investment would be worth $1375.

So as you can see, the risk is hard to quantify as it involves a lot of hindsight.

Risk is hard to quantify, and it comes in many forms; inflation risk, investment risk, timing risk, economic risk, and currency risk.  These are all external risks to your investments. You must also include the risk of the investment itself- the risk of not getting the returns you were looking for, or worse, not getting back your money at all.

Generally speaking, all investments come with a certain level of risk. Lower risk is commonly associated with a lower potential return, while a higher level of risk is associated with a higher potential return.

Fortunately, all these risks can be minimized with a well-diversified portfolio of investments.

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