Risk is an important subject in life, and vital in investing. Even novice investors understand that there is some trade-off between risk and potential returns. However, most investors tend to want to take a balanced approach to risk, and very few are cavalier on the subject. The following article will look at some types of risk, how to reduce them, and misconceptions about the subject.
Types of risk
There are too many types of risks to speak about here, but below deals with some of the most important types of risks:
Political and legal risks
A gain only occurs once you sell, and hence no gain can be achieved if your investment has been confiscated from you due to a nationalistic government being elected, or new laws which enact confiscatory tax rates.
In addition to the above, if you can’t sell an investment because you can’t find a buyer, then you could be left with absolutely nothing. Land, property and illiquid funds all have risks, including hidden risks, which liquid cash and property investments don’t have.
Currency risks and inflation
Your returns can be dramatically reduced if you invest in a financial instrument which is not denominated in a currency which you plan to spend money in, or if inflation is higher than expected.
Credit or default risk
Of particular concern to investors who have government or corporate bonds in their portfolio, is the risk that the entity will not be able to pay their bills – witness the threat of certain European governments for investors to take `a haircut`.
Interest rate risk
When central banks unexpectedly increase or decrease the base rate, all asset classes are affected. Typically currencies tend to rise, whilst real estate, gold and any speculative investment funded by debt decrease.
This is particularly important for short-term investors. Short term news changes the price of securities instantly – sometimes by many percentage points if leverage is used by major financial institutions to short a stock or currency. Timing markets is almost impossible, and hence volatility due to unexpected news can hit speculators hard.
People tend to decide to do something if two conditions are met: they are uncomfortable about where they presently are and comfortable about where they are going. Therefore one of the risks of thinking about risks all the time is……that you will do nothing! As a result of this you will be one of those people who will not have the money to retire when you want or do the things that you want to do, when you want to do them.
How to reduce financial risk
Have some cash
In most situations having too much cash in current accounts is foolish because the rates of returns are so small. But having 6 months living costs in savings, in a currency with a track record of maintaining some value, makes great sense in case the worst case scenario happens.
Protect your income and health
Most people wouldn’t dream of buying a $200,000 house and not insuring it, or a $50,000 car. But your health really is your wealth. If you are disabled, especially as an expat living abroad, who is going to pay the bills? Your social security back home won’t. Quality health and income protection insurance is cheap relative to the cost of losing your health.
Diversifying doesn’t mean investing in every asset class. But it does mean having a balanced portfolio, or accepting that having an unbalanced abroad might lead to big falls as easily as big gains. Having a cushion in liquid cash, one house as your home provided it is not overly leveraged, little or no debt, equities in developed markets and SOME developing markets and commodities makes sense for most client’s risk profile.
Avoid leverage and illiquid funds
Avoid stretching yourself to buy a house and thereby ensuring you not only can’t move for a pay rise, but might get yourself in negative equity. Avoid funds which are illiquid regardless of past performance unless you want to expose yourself to a lot of hidden risk.
Timing markets is very difficult and most people don’t have a lot of self-control. Therefore, saving monthly in a way that ensures good habits, is an excellent way of having self-control. Direct debits linked to an investment account are one such option. Moreover, dollar cost averaging means that monthly savings get you out of the timing trap. In other words, even if markets fall, you can make money if you are patient as you are buying cheap.
Save for the medium or long term
Partly linked to the last point, medium and long term investors do not need to keep logging into their accounts to check values. As much as timing markets is difficult, a market crash can even help those investing for the long-term, provided they have cash lying around,
Do not panic if your account is down, and in some situations, see it as a buying opportunity!
Don’t become too enthusiastic when the going is good!
As Warren Buffett said, if too many people are on one side of the boat, one should be worried. Bubbles occur when people get too bullish about the outlook for one particular asset class. Don’t be that person who buys your 5th house on mortgage, assuming that the value is going to keep going up and up.
Don’t assume that as a UK expat you can get free NHS healthcare if you get sick whilst overseas, that the average age of death and retirement won’t change, that you will have enough in retirement, that you will get a specific sum from inheritance and that you will always have a stable job and business.
But if you are going to make just one assumption…….
Assume that you may never have enough. Take any figure you have in mind, whether that is your ideal retirement income or your six month savings cushion, and double that figure. Few people ever have enough. And if nothing happens, no harm has been done.
Some misconceptions about risk
There are so many misconceptions about risk. I will just deal with a few of the most common:
Risk/volatility are the same thing
They are not. The Soviet Union seemed `stable` before it collapsed, as did the housing market before the financial crisis. If an investment is not moving too much to either side, that could be because there are investors with differing opinions (which is sometimes a good thing), or it could be because of other reasons. Perceptions change. Especially with individual firms. Malaysia Airlines doesn’t look as stable as it did last year, because the facts have changed.
Property is a safer investment than stocks
Real estate is a medium-risk investment in most markets. Yes everybody needs to live somewhere, but they don’t need to buy a place. It is an illiquid asset, which has the risks which were alluded to earlier. There is fire and flood risk, re-sale risk due to a lack of buyers, more tax risks than stocks, it is harder to hide from a partner in the event of a divorce and it brings about many social, legal and political risks. Moreover, over the long-term, stocks in developing markets tend to outperform real estate investments. This is because companies tend to become more efficient over time. The 100 biggest firms in the world today are clearly more efficient than those 50 years ago. As technology improves, the very best firms in a generation from now, should be more efficient than those today. In comparison some of the factors that have given rise to rising property prices – i.e loose monetary policy, women joining the workforce and increasing household earnings and rising population levels – aren’t likely to continue into the next generation in many countries.
Physical assets are less risky
One can touch property, land, gold, cars and so forth. That doesn’t mean they are safer. To the contrary most of the aforementioned assets can be inherently risky, especially if you invest in them in the wrong way. If you are really bullish about property prices in, let’s say Canada, and you don’t plan to live there, investing in a reasonably priced fund which tracks the price of 50 property developers in the North American market might well be a better bet than buying just ONE property.
In essence, if you don’t want to take risks, don’t invest, which is the biggest risk of them all.