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.