Friday, 15 August 2014

Understanding Risk in an Uncertain World


Risk can take on many forms and is ubiquitous in daily life. Risk can range from skydiving to forgetting to bring home flowers on Valentine’s Day. Risk can mean taking a shortcut to get to your meeting to starting up your own business.

With regards to investing, risk is ‘the chance that an investment will lose its value.’ In prospectuses provided by fund companies, there are generally more than 25 types of risks listed. Several forms of risk can play a more significant role in your portfolio than others. Some of these include:

Market risk: This type of risk is associated with similar investments that lose value due to broad issues within the market or during various stages of the business cycle. It may be difficult to drown out the ‘bull’… and ‘bear’ market noise but downturns are expected in the general upward trend line of the market.

Credit risk: The ability of a company to pay back its debts is measured by its credit risk. Higher yields are paid to attract investors to companies that have a higher risk of defaulting on its bonds and debt obligations. 

Geopolitical risk: Wars, political instability and similar headline news all have a strong effect on the markets as conflict is a hindrance to robust economic growth. Currency risk can be coupled with geopolitical uncertainty as the demand for a country’s money can decrease when the  political, economic and social environments become unfriendly to investment.

Interest rate risk: Interest rates have a significant impact on fixed income securities. As a general rule, a rise in interest rates leads to a decline in the value of bonds and vice-versa. In addition, highly leveraged companies and governments are vulnerable to higher interest rates as the interest expenses paid on large amounts of debt becomes increasingly difficult.  

Inflation rate risk: Fiat money (currency not backed by a commodity but rather government regulation) is subject to inflation. An increase in money supply leads to inflation and erodes purchasing power of a currency. Inflation should be subtracted from the nominal return on an investment to get the real return.

Longevity risk: The chance of outliving one’s money is one of the most important issues to address when planning for retirement. Calculating how much an individual needs to save for retirement requires weighing factors such as life expectancy, income needs, saving rates and whether a sizeable estate will be passed onto heirs.

While high-risk investments have the potential for large gains, they carry the potential for greater loss. Likewise, taking little to no risk offers no meaningful return. The way to mitigate against the myriad of risks in the marketplace is to maintain a well diversified portfolio. This tried and tested manner of investing is the best way over the long term to reach the best risk-adjusted returns.

Tuesday, 20 May 2014

Patience is a Virtue… and Profitable


The importance of human behavior and patience in determining investment success

Long-term investing is making prudent buying decisions of low priced, solid investments that are to be held for an extended period of time. To realize the full return of these investments, you must hold to a set of principles and behaviors to counter human reactions common in the marketplace. This requires a great deal of patience. Overcoming psychological roadblocks which affect investing decisions means you must confront your biggest enemy: yourself.
           
Holding to a solid set of principles can prove more valuable than technical knowledge. Here are some of them:

1) Avoid frequently reading share prices.
Glancing at daily price movements adds no value to your portfolio, as it may entice you to sell or buy on a whim. It is better to look at quarterly and better yet, yearly returns. It is important to be aware but not consumed by the economic environment—cycle swings are inevitable but have a limited effect on long-term portfolio performance.

      2) Intrinsic value should be the decisive factor when making investment decisions.
‘Price is what you pay. Value is what you get.’—Benjamin Graham. Buying low cost, under priced stocks and mutual funds is a much more sure way of realizing your investment and retirement goals. Prices reflect the current opinions of what others think the stock or mutual fund is worth. These constant changes of opinion should not affect the long-term value of the holding.

      3) Buy a fixed dollar amount of stocks over time regardless of price.
This is known as ‘dollar cost averaging’ which lessens the risk of investing a large amount of money into a stock or fund at the wrong time. The price per unit or share will eventually become smaller and smaller over time, buying more shares when they are low and less shares when they are high.

     4) Short-term thinking should never trump long-term goals.
Market volatility is a short-term phenomenon. With a properly diversified portfolio based on solid funds, long-term investing provides significantly less risk.

By taking a disciplined approach toward your investments, the urge to buy or sell on a whim begins to dissipate, avoiding human tendencies of both panic and greed. Sticking to solid values not only allows for your investment and retirement goals to be more likely realized but also allows for a peace of mind—something that is hard to come by in the investment process.