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March 2009 Article - What is Risk?
Pete
Posted: Wednesday, August 4, 2010 11:32 AM
Joined: 01/12/2008
Posts: 47


What is risk?

The volatility in markets looks set to continue through 2009 and so many clients have asked me how to
reduce the risk of their investments; I like to ask them to consider "what is risk?"

The dictionary defines risk as: exposure to the chance of injury or loss; a hazard or dangerous chance.
From a financial point of view the key word here is LOSS and with this in mind let's look at some of the
different forms of risk.

Inflation risk: as time passes the COSTs of goods and services tends to increase; this effect of inflation eats away at the real value of money 'its buying power'. This must be considered as a real "chance of loss". $10 000 today in cash will only really be worth approximately $7765 in 10 years if inflation remains at 2.5%. This is a real loss in of $2236 or 22%. Many savers rarely consider this as a 'risk' though today it is even more important than before. Interest rates around the world are at historically low levels and even though short term inflation has fallen it is still positive. This means that money in most cash accounts will suffer real losses over the next few years.

Investment risk: we have seen very high levels of volatility on many different markets over the last 12 to 18 months. Many people define “volatility” as risk, though this is not really the case. Consider if you buy a share because you believe that the value will increase over time, but suddenly you need to access the money and the markets have fallen. This volatility is now a real "chance of loss" as you have to take your money out. If you don't need the money for another 10 years and still believe that the investment is a sound one then the volatility of the value should be irrelevant, though of course it can be unnerving!

Shares are typically more volatile than many other assets, but over the longer term tend to provide significantly greater returns than other assets. If the timescale is right and the investment choice is sound then the "chance of loss" reduces greatly over time. Some current portfolio theories state that as you approach the time when the money will be required then a steady switch from ‘highly volatile assets’ to ‘lower volatility assets’ should be carried out as this reduces the "chance of loss" considerably and therefore the real RISK.

Default Risk: This is the genuine "chance of loss" if the corporation you invest in goes bust or can’t repay your money. This risk is more understood when using shares or bonds and is part of the risk:return consideration but has come to the fore recently with the current problems in the banking system. Without the interventions of many governments many ‘safe’ savings may have disappeared. It is worth understanding fully how much of your money is now ‘protected’ by the bank rescue plans.

Short fall Risk: unusually this risk isn’t always where the "chance of loss" is necessarily as you would think, as your funds may have grown considerably over time. A short fall risk is one where a certain amount of money is required sometime in the future to repay a liability, like a loan or mortgage. If the money deposited doesn’t grow enough to repay the future liability this would be considered a short fall. Recent UK endowment policies are good examples of this.

Opportunity Risk: this is the risk of genuinely missing out on a good opportunity because all of your investible 
money is tied up in other schemes. This is avoidable by maintaining some ‘liquidity’ in a portfolio and sacrificing a little return for greater flexibility.

Psychological risks: this could be termed “the fear of looking stupid”. Many investors tend to make important investment or financial decisions because they either don’t want to miss out on something or don’t want to look stupid in front of their peers. This can easily be avoided by a little SELFISHNESS! Stick to your guns – investments and savings will only work for you if they are suitable for YOU (i.e. your situation, attitudes and timescale).

In fact many ‘contrary’ investors do better than those who ‘follow the herd’. The "chance of loss" here lies investing into the “next big thing” when it is already too late; buying at the top or selling at the bottom… the exact wrong way to invest!

This article has barely scratched the surface of a very complex subject, but the key considerations are:
1. Volatility does not necessarily mean Risk, though it is a good ‘measure of short term risk’.
2. Inflation is a real risk consideration.
3. If it sounds too good to be true, it probably is.
4. All risk is manageable with good advice and careful consideration.

This article is for information only and should not be considered as advice.

Peter Brooke is a financial planner to the English speaking expatriate community. He is based on the Cote D’Azur and is a member and partner with the Spectrum IFA Group. He can be reached on +33 6 87 13 68 71, at peter.brooke@spectrum-ifa.com or at www.spectrum-ifa.com/riviera2.html

This article was published in the March 2009 edition of Dockwalk magazine.

 
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