What is investment risk? Before you start any financial plan you need to understand the risk, many of us aim in life to avoid risk, but there is no such thing in today’s world. Whether you’re simply walking down the street to buy a pint of milk or investing your savings in the stock market there’s a risk!
Most people when they think of investment risk automatically think about being defrauded or losing all their money. This is deemed as “capital risk” and whilst very important it’s not the only type of risk that needs to be considered.
So what else should we consider?
When you are young you can afford to take a greater level of risk as you have time on your side, time to replace any lost capital or time to see out an investment cycle (bear to bull market). When you are older perhaps during or near to retirement higher risks leading to any investment loss are much harder to stomach. So no matter what the potential return we again try to avoid risk, often this leads to us leaving our capital in the bank yielding low interest rates, often below inflation, meaning our buying power is being eroded. This type of risk is known as “inflation risk”.
Another form of risk is “Shortfall risk”, this means failing to reach your investment goal because the return on your investments is too low. For example, say you want to save €20,000 and can get a return of 3.4% from a savings account. This means you'd have to save €140 a month to reach your target. If you can only save €100 a month, you'd need a return of 6.9%. To reduce shortfall risk, you need to invest at least some of your money for a higher return but this may involve taking some capital risk.
“Share-based risk” is a bit more complex as there are so many different types of instruments carrying different levels of risk. For example buying a single share in a company operating in a single market will carry a different risk to holding a unit in a fund investing in the same market.
Some companies will fluctuate more than others and may be impacted by external forces in other markets. If you’re new to investing you should aim to start by being more risk adverse and invest with well known companies. You can reduce your risk by investing across a range of shares. This way, if one of them goes bust, or falls heavily, the overall effect on your portfolio is less. The best and cheapest way to spread your risk is to invest in pooled investments like unit trusts. They are called pooled investments because you pool your money with other savers to buy a wide range of shares.
“Market risk” is the risk of a fall in the particular country's stock market where your money is invested. When a market falls you will usually find that most shares are dragged down with it. Some fall by more than the average, some by less, but few escape the trend all together. You can reduce market risk by diversifying your investment across multiple stock markets and industry sectors around the world. This is basically spreading your bets and works on the principle that not all stock markets will rise and fall together. Global markets are closer than ever these days but still don’t work in complete harmony. For example, if you hold stock in the automotive sector and pharmaceutical sector should one crash your losses will be limited as the other may have risen.
“Currency Risk” if your money is invested in stock markets outside the country and the currency that you are spending every day, then you are exposed to fluctuations in currency. At some point you will have to convert the investment back into the currency that you commonly use. If your money is in a country that the currency has moved against your own country’s currency then this may have a positive or negative effect.
Again you can limit your currency risk by diversifying via pooled investments that invest globally. Alternatively you can avoid currency risk all together by sticking to your own currency i.e. Euro investment only in Euro countries, However this does increase your market risk.
“Manager Risk” there are thousands of fund managers out there all making their own bets on the market, some are better than others and picking the right manager is no easy task. You need to look for a manager that has a long standing history, working for a company with a solid reputation and a good level of money under management.
How do you decide what risk to take?
Determining your own attitude to risk is crucial before embarking on any investment. This is something that only you can decide; you shouldn’t be lead by others or be influenced by huge returns. You need to manage your own risk and also your own expectations, be realistic if you are a low risk investor you should not expect to double your money overnight. Even in the good times you need to manage your greed, all too often investors stick with the same investment strategy for too long or stay in an over inflated market that suddenly collapses. Think about the timescale you are going to invest over. The longer you have in the market the more risk you can afford to take as you have more time to make gain or ride out a recovery. Your attitude maybe different on different types of investments, you may be prepared to be more risky on a monthly savings plan that matures in 20 years and be less adventurous with the money you are saving to buy a new house.
There are hundreds if not thousands of financial instruments available so deciding which solution is best for you can be a laborious task. It’s important to find a good independent financial adviser who will help you to determine your own attitude to risk, especially if you are not a confident or experienced investor. They can talk you through all the areas of risk, giving you peace of mind that you are making an informed decision.
You can contact me Daniel McGonigle, Managing Partner at Affinity Global Wealth (+351) 289 314 530.
E: daniel@affinityglobalwealth.com
W: http://www.affinityglobalwealth.com/
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