July 7, 2024
Risky Business
In investing, or life for that matter, there is no return without risk. Whether it is the uncertainty of market fluctuations or the potential for unexpected economic events, investors must constantly navigate a landscape where outcomes can differ significantly from expectations. This inherent uncertainty creates risks that make the financial market both a place of opportunity (potential gain) and potential losses.
What is Risk?
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Risk, in financial terms, is the possibility that an investment’s actual return will differ from what was anticipated, potentially resulting in the loss of some or all of the invested capital. Investing has risks, but it can be managed and reduced. While it is true that we cannot eradicate risks from our investment portfolios, in the famous words of Warren Buffett, “Risk comes from not knowing what you’re doing.” This means you can reduce your risk by increasing your understanding of investing, its associated risks and learning how to manage them. In this article, we will discuss risk management and explore ways to mitigate risks in your investment portfolio.
Managing Risk
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You cannot manage what you don’t understand. Therefore, understanding the relationship between risk and reward is a fundamental principle of finance that you must learn when investing. The key thing to know is higher returns typically come with higher risk, while lower risk generally means lower potential returns. In finance, this is known as the risk-return trade-off. Unfortunately, there is often a disconnect with investors – they often want high-return low-risk investments and there is no such thing.
Evaluating the riskiness of various assets involves assessing the potential for loss (risk). Two types of risks an investor may face are credit and liquidity risks. Credit risk is the risk that a borrower will default on their financial obligations, failing to make required payments on time. This can result in a loss of principal and interest, impacting lenders and investors. Investors could face credit risk with corporate bonds, where the company might default on payments, and with high-yield bonds, which offer higher returns but have a greater chance of default. On the other hand, liquidity risk is the risk that an asset cannot be quickly converted to cash without adversely affecting its price. Liquidity risk is evident when investing in assets like real estate or certain stocks that may be hard to sell quickly—due to limited trading activity—without losing value. Safer assets, like government bonds and savings accounts, typically have low risk and provide modest returns, and they are often highly liquid, meaning they can be quickly converted to cash with little impact on their value. They also typically have lower credit risk relative to other assets in that market. Moderately risky assets, such as corporate bonds and blue-chip stocks, offer higher returns but come with greater risk versus a government bond and varying degrees of liquidity. High-risk assets, like speculative stocks and bonds and venture capital or private equity investments, generally yield substantial returns but also carry a significant potential for loss and are often less liquid.
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Risk analysis
Before creating a diversified portfolio, performing a risk analysis is crucial for investors as it focuses on understanding your appetite and ability to take risks, and what it means for the amount of risk that you should be taking when investing. This self-assessment helps determine how much risk you are comfortable with and can withstand without compromising on your financial goals or peace of mind. By evaluating both your risk appetite, which reflects your attitude towards risk-taking, that is, the amount of risk you are willing to take, and your risk capacity, which indicates the level of risk you are willing to accept to achieve specific objectives without jeopardising your financial stability, you can determine your risk profile. That is whether you are conservative (risk-averse), moderate (risk-neutral), or aggressive (risk-seeking) in your investment approach. Conservative investors prioritise protecting their original investment from loss and are comfortable with lower potential returns, typically favouring liquid investments and avoiding volatility. Moderate investors take a balanced approach, seeking a mix of safety and moderate returns, while accepting some level of risk. On the other hand, aggressive investors are willing to endure uncertainty and the risk of losing a significant portion of their investment in pursuit of potentially higher returns, often focusing on capital appreciation and having a higher risk tolerance, especially when they are younger. Age and psychological factors also play significant roles in shaping your risk profile and influencing investment decisions. What is your risk profile? Contact your wealth advisor and take an assessment to find out. Overall, knowing your risk appetite and tailoring an investment strategy that aligns with your risk profile and psychological make-up is crucial for properly managing and mitigating the risks associated with investing.
Diversification
How do you deal with the fear that you will lose everything in an investment? Think of the adage “Don’t put all your eggs in one basket”. This is the principle of diversification at play. Diversification is a fundamental principle in managing risk when investing. It reduces risk in any given portfolio by spreading investments across different asset classes, sectors, and regions. This strategy ensures that if one investment performs poorly, others may perform well, thereby balancing the overall portfolio. For example, during the 2008 financial crisis, many investors who were heavily invested in financial stocks suffered significant losses in their portfolios. However, having a diversified portfolio can help to mitigate the downturn. A well-balanced diversified portfolio that includes various asset classes, from various industries, and geographic regions can provide more consistent returns and help mitigate risks over time. This diversification strategy helps to ensure that not all investments are affected by the same market conditions, thereby reducing the overall risk of losses and enhancing the potential for long-term growth. Importantly, while diversification doesn’t eliminate risk, it minimises the impact of any single investment’s poor performance, helping to achieve more consistent and reliable long-term returns. In the end, this balance is the impact you have when you diversify your portfolio, whereby you try to balance risk and return.
Bottom line
We all face risks every day and while you cannot fully eliminate risk, by incorporating effective management through diversification, risk analysis and management, you can proactively optimise successful outcomes by minimising threats, thereby maximising returns. However, many potential investors are paralysed by the fear of losing their money, which prevents them from taking action, but not investing is a risk in and of itself. Holding all your cash in savings can be detrimental due to inflation, which erodes the purchasing power of money over time. Investing is one of the most effective strategies to protect your savings from losing value as the cost of living increases. Therefore, investors need to understand risk and learn to manage it to achieve more consistent and reliable long-term returns. Managing risk involves understanding the balance between potential returns and potential losses, as well as understanding the asset you are investing in. Factors such as risk appetite, risk capacity, age, and psychological makeup can shape an investor’s risk profile and influence their investment strategy. Ready to optimise your investment strategy and manage risks effectively? Contact your NCBCM wealth advisor today to discuss how you can create a diversified portfolio aligned with your risk profile. Start safeguarding your investments and maximising potential returns in today’s dynamic financial landscape.
