Risk - Know your risk types to become a successful investor.
This article is written as banks around the world are disappearing and stock markets are falling. Certainty is a thing of the past. World famous institutions have been reduced to shadows of their former selves.
Amongst this chaos ordinary investors have to find a way of meeting their investment objectives. Risk is one aspect and one which is often misunderstood. So perhaps the first thing to do is to understand the different types of risk that relate to investment. Here we have given a brief description of the different types of risk and what to do to reduce the risk.
Investment risk - volatility
This is the risk that most people think of when considering an investment. Put simply, will the value of my investment go down because of poor performance by the investment I have invested in. Obviously a good question and an important one. Yet many investments fall in the short term and over the long term produce good returns. High risk does not always mean high returns but often the high returns come during a very short “spurt” of growth, If you miss this period of growth you may not be rewarded for the higher risk. The risk is often, therefore, in having to withdraw your money from the investment during a down period or before the growth “spurt”. Investments that provide consistent, year on year returns often produce lower returns, despite their steady returns. Investment risk is associated with the volatility of an investment.
How to reduce Investment Risk
Firstly, don’t use just one type of investment. Different types of investments go up and down at different times, sometimes even at opposite times. For example, when shares fell after the dot com boom from August 2000 to March 2003, government bonds rose over the same period.
An efficient frontier theory was developed by Harry Markowitz. We do not need to go in depth to the theory that won him a Noble prize but the principal was “diversification gives you the best balance between risk and reward”. Diversification is advisable and can be considered across ALL your investments. Do not caught in the trap of looking at a portfolio for your different type of plans: pensions, savings, buy to let etc. You should view your TOTAL assets when making a portfolio.
Inflation Risk
The risk posed by inflation is one of the biggest risks for longer term investors. As prices rise the amount your money can buy is less. The cost of an item might be 10€s at the beginning of a period but with inflation at 5% per annum it will cost 20€ in 12 years time. For investors living on income from their investments this is a serious issue.
How to reduce inflation risk
Add investments to your portfolio with returns over and above the rate of inflation. This could include index linked gilts, property and shares. The Barclays Gilt Equity survey tells us that over the long term shares outperform inflation by 6.7%. Bank deposit accounts are the asset class which struggles to keep up with inflation.
Third party risk/credit risk
This is the risk of our time. The risk of a company that you place your investment with going into liquidation, bankruptcy or partial nationalization is a risk affecting millions of people. With investment risk the value of your investment may well fall, and even substantially, but there will often be some residual value. With credit risk, if a company goes bust you join a list of creditors and you may receive nothing at all.
In terms of the financial institutions in Europe there is often some protection for investors. Much has been made of the various deposit protection schemes for investors in banks. In many cases, similar schemes are in place for insurance company products and fund management houses.
How to reduce Credit Risk
Firstly, you should check what activities the institution partakes in. Is it a bank, an insurance company or a fund management company. Secondly, check that it is regulated. Ask what protection it has in terms of investor protection. Check that your investments are ring fenced from the company, if possible.
Foreign Exchange or Currency risk
If you are an investor living outside your home country you have another risk to assess. If you have investments in a different currency than that of your country of origin or residence then you are exposed to more risk. Differences in exchange rates can dramatically enhance or reduce the return in your local currency. Exchange rate movements are also very fast and it is almost impossible for private investors to move their money as quickly as institutional investors.
How to reduce Currency Risk
Invest in the currency where you will spend your money is a good way to minimise your currency risk. If you live in Spain and your expenditure is in Euros, invest in Euros. This way if you have to spend money to live on, pay the mortgage etc you will not be caught out by a sudden currency movement.
Country Risk
Countries often go through economic cycles and sometimes political cycles. If you have all your money in one country your investment will reflect the position of the country in its cycle. In the current crisis a very unfortunate example of this is Iceland. Investing only in that country would have resulted in your investments becoming “locked in”
How to reduce Country Risk
The obvious way to do this is to not allocate a significant proportion of your investments into just one country. British and American investors in particular often have a bias of 70% or more to their home countries. This is not necessarily a good allocation. Your attitude to risk will also however, play a part in where to allocate your investments.