A crucial step to achieving long term financial security is recognising the importance of (and the relationship between) investment risk and return. In practice, this means implementing an investment strategy which matches your personal objectives and risk profile.
When I am speaking to clients about investing for the first time, they generally fall into two categories:
- The Risk Averse
- The Not So Risk Averse
Normally, within the first two to three years, one category changes their mind and changes to the other. Can you guess which one?
If you replied the risk averse becoming the not so risk averse, you would be right. This usually stems from clients becoming more comfortable with the idea of investing and the fact that taking risk can, when understood and applied properly, have a staggeringly positive effect on your portfolio.
There are many different reasons as to why people invest and no two people will have exactly the same objectives. Risk is a necessary and constant feature of investing – share prices fall, economic and political conditions fluctuate and companies can become insolvent. Therefore, understanding your risk profile is an important consideration before you actually invest.
Your risk profile is the relationship between your investment objective, risk tolerance and capacity for loss. As a result, you should be aware of your ability and willingness to accept risk and what level of risk might be required to meet your investment goals.
Investment profiles broadly fall into one of the following three categories:
Low Risk Profile
People with a low risk profile wish to preserve their capital and understand that there is very little scope for significant capital growth. These portfolios are heavily weighted to investing in cash and bonds.
Medium Risk Profile
People with a medium risk profile understand that to achieve long term capital growth, some degree of investment risk is necessary. Portfolios for this category of investor are usually balanced between cash, bonds and shares (equities)/equity funds, with perhaps some exposure to property as well.
High Risk Profile
People with a high risk profile are those who are prepared to accept the possibility of a significant drop in their portfolio values in order to maximise long term investment returns. Higher risk portfolios have a far greater weighting towards equities/equity funds and less exposure to bonds and cash.
Different kinds of investment carry different levels of risk:
Cash or savings accounts are often regarded as ‘low risk’, yet, as the credit crisis of 2007 – 2008 showed, they are not ‘risk free’. Inflation will also reduce the value of cash savings if it is higher than the rate of interest being earned. At the time of writing, inflation in Belgium is just above 2% and the interest rate is 0%, which means that you are effectively paying your bank to hold your cash savings.
Bonds or fixed interest securities are popular with many investors. If you invest in these instruments, you are essentially lending money to the issuer of the bond; usually a company or a government. In return, the issuer pays interest at regular intervals until the maturity date. The obvious benefit to the investor is regular income. However, there is a risk that the issuer may not be able to maintain interest payments and the capital value of the bond can fluctuate.
Although past performance is not a guide to future returns, historically the best long term investment performance is produced by equities or equity funds. The increased level of risk associated with equities is directly linked to the higher returns typically available from this type of asset.
The price of a company’s shares trading on a stock market is a reflection of the company’s value as influenced by the demand (or lack thereof) from investors. Essentially, when you invest in a company you are buying part of that company and hence able to share in its profits. The converse is also true, so you could be exposed to operating losses and a fall in the company’s share price. The risks, therefore, can be high, especially if you own shares in only one or a handful of companies. Equity funds, run by professional managers and which usually invest in a range of companies, are a means of avoiding such concentrated risk.
TYPES OF INVESTMENT RISKS
There are several types of investment risk that the you can be exposed to if and when you decide to invest, and you should be aware of the possible effect on your portfolio before you start:
Also known as systematic risk, it means that the overall performance of financial markets directly affects the returns from specific shares/equites. Therefore, the value of your shares may go up or down in response to changes in market conditions. The underlying reason for a change in market direction might include a political event, such as Brexit, government policy (consider current US-China trade tensions) or a natural disaster.
This refers to the uncertainty in a company or industry investment, and unlike market risk, unsystematic risk applies to only a small number of assets. For example, a change in management, an organisation making a product recall, a change in regulation that could negatively affect a organisation’s sales, or even a newcomer to market with the ability to take away market share from the organisation you are investing in.
This is the possibility that an event at company level has the potential to cause severe instability or collapse to an entire industry of economy. It was a major contributor to the financial crisis of 2007 – 2008. Think back and you will remember the phrase that Company X ‘was too big to fail’. If it collapsed, then other companies in the industry, or the economy itself, could fail too.
Investment options include shares/equities in a range of currencies. Changes in exchange rates can result in unpredictable gains and losses when foreign investments are converted from the foreign currency back into your base currency, from US dollars into Euros for example.
Portfolio Construction Risk
This is the possibility that, in constructing a portfolio, you have an inappropriate income/growth split, or that you fail to monitor and manage the portfolio in line with your investment objectives. There is also a risk that you select assets that are inconsistent with your risk profile.
Interest Rate Risk
Interest rate risk is the possibility that an investment held will decline in value as a direct result of changes in interest rates. For example, bond prices are usually negatively affected by interest rate rises.
This is the possibility that you over-invest in a particular asset, sector, industry or region, which removes valuable diversification from your portfolio.
This is the risk of being ‘under-exposed’ to other types of investments that could potentially deliver better returns.
Whether you are investing on a regular basis or have invested a lump sum, it is imperative to understand how risk, or your attitude to risk, can fundamentally affect the potential growth of your investment.
The above article was kindly provided by Emeka Ajogbe from The Spectrum IFA Group and originally posted at: https://www.spectrum-ifa.com/understanding-how-risk-affects-your-portfolio/