Sound investing requires risk management

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The stock market turmoil connected to the Global Financial Crisis, and the subsequent effects on the world economy have taught us that investment strategies involve degrees of risk. Risk may be with the actual investments, the strategy applied, or simply the prevailing investment climate. Experience in the US and in Europe with investments known as ‘Derivatives’ shows that the degree of risk and the ownership of that risk is not always known to the investor because of the practice of on-selling securities.

Nevertheless, this highly speculative form of investing should not dissuade people who want to provide for their future through an investment strategy. Done properly, perhaps prudently, investing can be an both aneffective long-term saving strategy and enabling growth in the investment cash-in value.

The great advantage of long term investments is that losses are suffered only when cashing in the investment, so if investors can ride out downturns then the odds are that things will get better. If investors are forced to sell during a downturn because they have adopted a short-term strategy without risk strategies in place then they have to take the loss. This is when people can suffer severe financial and asset losses. This is particularly so when investors chase higher and higher returns, with commensurately higher and higher risk. When the correction inevitably comes it will likely be severe.

Most analyses show that long-term strategies employing risk management practices always beat the ‘get rich quick’ fad schemes. Clear evidence for this lies in the Global Financial Crisis and subsequent downturns during which many people speculated in a rising pre-GFC market only to see the value of their investment fall dramatically without enough warning to divest themselves of short-term securities. Worst case is when people borrow money to invest, and when the investment becomes a fraction of its bought value the lending institution calls in the loan, leaving the investor out on a financial limb.

The question is whether your investment decisions will lead to the right investment package that suits your future goals, circumstances and lifestyle?

This article aims to help you:
* understand risk from a broader perspective
* examine different types of investment risk
* think about strategies to protect your investments by reducing your exposure to risk.

It’s important to understand and be comfortable with potential investment risks. Remember, it’s your money you are investing, and you need to monitor and make adjustments along the way. You don’t need to be speculative and constantly move money around chasing higher returns, but rather oversee what people and financial institutions are doing with your money.

No one is immune to risk but speculators are at greatest of risk. It’s easy to be a ‘high flyer’ when markets are buoyant but speculators come unstuck in an inevitable downturn.

Understanding Risk

Most people think of ‘risk’ as the risk of short-term capital loss. However, there are a number of other risk factors. For example:
* will your savings buy as much or more in the future (at future prices) as they do today?
* will you have enough money for your intended lifestyle and independence in retirement?
* will you have timely access to your funds in an emergency?

Investors who take the super-safe option of keeping their money in a bank account or a capital guaranteed option are also exposed to risk: the very real risk that inflation will eat away at the value of their funds over time.

So, how do you manage risk and achieve your investment goals? In general, when you make an informed decision to take on some level of risk you create the opportunity for greater reward. This is a fundamental principle of investing called “the risk/reward trade-off.”

Mismatch Risk

There’s no one-size-fits-all solution when it comes to investing. What is a perfectly sound investment strategy in one situation can be highly risky under different circumstances. This is called ‘mismatch risk’, which is an investment that is inappropriate for your particular needs and circumstances that could result in a loss of some sort. Minimise mismatch risk by focusing on your investment objective and timeframe.

Investment objective

Think about your investment goals, in the short and long term. Are you investing for income, capital growth or a combination of the two? Your goals might include: saving for a deposit on a home, saving for children’s education in ten years time, or building wealth for retirement in 15, 20 or 30 years’ time.

Timeframe

Sometimes you will want to invest for a short time only, perhaps for a specific goal; other times you may be able to take a longer-term view, aiming for growth of your capital. Typically, the following guidelines apply:|
* Short-term (less than 12 months) – Cash
* Medium-term (at least three years) – Emphasis on fixed interest with some cash and growth assets.
* Long-term (more than five years minimum) with an emphasis on growth assets (shares and property).

Inflation

Because of inflation a dollar today will not buy as much as it will ‘tomorrow’. Even if the rate of inflation remained at a relatively low three per cent for the next 15 years, a one dollar purchase made today will cost $1.56 in 15 years’ time.

Inflation is therefore an important consideration for all investors. If the after-tax return on your investments is less than the rate of inflation, then the real value of your money is in decline.

To protect your investments from the impact of inflation you need to achieve at least some capital growth. While fixed-term deposits and savings account type investments can provide you with a regular income, your capital value remains the same – but its value decreases with inflation. Many people fall into the trap of choosing these investments because they are regarded as safe, but there is a risk that they will not keep pace with inflation and their real value will erode over time.

Diversification

Diversification means spreading your money across different investments to effectively spread the risk. The better you diversify your investments, the less likely it is that poor performance from one investment will have a major impact on the value of your total portfolio. However, diversifying into several funds can attract increased management and other fees that erode returns, so for smaller investors a single fund that has diversified investment elements may reduce these costs while offering adequate investment spread risk.

Market

Market risk refers to volatility, or the extent to which the market value of your investment will fluctuate, moving down as well as up. This is particularly visible in recent times when there has been volatile fluctuations in equity (share) values. Investments expected to produce higher long-term returns generally experience greater volatility in the short-term. Volatility becomes a problem if you don’t have the timeframe to ride out the rough patches. Historically, investors who stick with long-term strategies generally go on to recover and prosper.

Reinvestment

If your priority is income then fixed income investments offer advantages but you are exposed to re-investment risk. Interest rates go up and they go down depending on the economic climate and circumstances, so a drop in interest rates when your investment matures means that your capital will then be re-invested at a lower rate. Your new investment will then provide a lower level of income, and because there is no capital growth component with a fixed income investment, there’s no extra capital available to boost your reduced income level.

Liquidity

You may be forced to draw on money deposited in long-term investments to meet short-term needs. This can result in a loss, from withdrawal fees or through having to sell investments when the market price is down. By keeping some funds aside in an accessible, short-term investment such as a cash management trust you can avoid this situation. Once you have your short-term needs taken care of, you can embark on a longer-term investment plan, confident that your long-term investments will remain just that – long term!

Advisers and Fees

While sound investment advice is imperative for most people there is risk associated with choosing the right financial adviser and the right portfolio for individual needs. When buying anything, and buying an investment package is no different, shop around and check credentials, conditions, costs and control is very important. Some investment portfolios may incur significant fees in commissions and ongoing management costs, and they may not be as flexible as you would want – incurring substantial penalties for early withdrawals, etc – and they may be ‘top heavy’ in diversification, incurring more and more fees.

Credit

Credit risk applies to debt-type investments such as term deposits, debentures and bonds. The risk is that the company to which you have lent money may become insolvent and unable to meet interest payments or to repay your funds.

Information is the best means for avoiding credit risk. If you are considering such an investment, ask for information about the company’s credit rating, past performance, ownership, etc. This should give a good indication of the quality of the organisation – and be wary of investments that appear too good to be true; they usually are. Diversification also helps reduce your exposure to credit risk.

Expectations

What can you expect from different investments? While growth assets produce the highest average returns, they also experience the greatest volatility. Typically, investments with the lowest volatility produce the lowest average returns. Likewise, those with higher volatility produce higher average returns over the long term. For example, twelve-month returns from an investment in Australian shares over the past 25 years ranged from -43 per cent to 86 per cent. This means that if you invested $10,000 at various times over the last 25 years, 12 months later your investment could be worth anything between $5,746 and $18,613. If, however, you invested your $10,000 for the whole 25-year period it would be worth $226,127.

Consultation

In establishing an investment strategy the Golden Rule is: spend a lot of time thinking about your requirements for future financial security, read as much as possible about the various investment products available, consult a qualified financial planner as to the various investment options, and armed with this valuable knowledge structure a portfolio that meets your requirements.

This consultation process is especially important for people who have demanding jobs and do not have the time or the expertise to effectively plan their financial future. Truly independent advice is critical to realising your future financial goals.

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