Sound Investment Practice 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, and that sound investing requires sound advice from qualified professionals.

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, done prudently, investing can be an effective long-term wealth creation strategy, enabling growth in the investment’s cash-in value.  The advantage of a long term investment strategy is that investors can ride out the downturns and wait until things will get better. A short-term strategy without risk strategies in place can mean heavy losses when investments have to be cashed in. This is particularly so when investors chase higher and higher returns, with commensurately higher and higher risk.

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.

Expectations

What do you expect from your 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 can produce higher average returns over the long term.

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. Armed with this valuable knowledge structure a portfolio that meets your requirements.

Understanding Risk

Most people think of ‘risk’ as the risk of short-term capital loss but there are a number of other risk factors:

•    will your savings buy as much in the future (at future prices) as they do today?
•    will you have enough money for your intended lifestyle in retirement?
•    will you have timely access to your funds?

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.

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. Minimise mismatch risk by focusing on your objectives and timeframe.

Investment Objectives

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.

Inflation

Because of inflation, a dollar today will not buy as much as it will ‘tomorrow’. To protect your investments from the impact of inflation you need to achieve 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.

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.

Market Risk

Market risk refers to volatility, or the extent to which the market value of your investment will fluctuate; importantly, 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.

Reinvestment

If your priority is income, 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.

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 having to sell investments at a low market price. By keeping some funds aside in an accessible, short-term investment such as a cash management trust you can avoid this situation.

Financial Planning

Sound investment advice is imperative but there is risk associated with choosing the right financial adviser and the right portfolio. Check credentials, conditions, costs, etc. Some investment portfolios may incur significant fees and ongoing management costs, and they may not be as flexible as you would want – incurring substantial penalties for early withdrawals, etc.

Credit Risk

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 cannot 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.

Disclaimer: The information in this article is of a general nature and is not intended to be specific advice on financial matters. Financial advice can only be provided by a qualified financial planner.

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