As financial planners, one of our key roles with investment management is to evaluate and manage risks with the investments of our clients. This article shows the different types of investment risk that you need to look out for when evaluating whether to make an investment.
When making an investment you need to consider all these aspects. You cannot evade risk, but if you understand it you will have a better chance of achieving your financial planning goals. We measure risk through a combination of due diligence, and quantification using statistical analysis. If you are not an experienced investor you may ignore these areas, which could mean that you take more risk than expected. Alternatively, you might want to reduce risk and so be ultra cautious, which could mean that you do not achieve the returns that you would like.
This is the risk that you will not be able to buy or sell an asset due to its nature or the market. An example investment could be property. The property market can be a good long-term stable investment; however, at the moment the market is depressed meaning that if you had made some property investments you might have to take a lower sale value if you need to sell at the moment.
High liquidity comes from more readily available assets such as large company shares, or government bonds.
Income and capital risk
This is the risk that the income is insufficient to meet your income needs, or that your capital obligation might be higher than the capital invested. An example with income could be if you are retired on a fixed income and inflation or interest rates overtakes the rise in your income. With regard to capital, you have the risk that your investment does not match your liability (say with paying off an interest only mortgage).
Some investments are able to borrow to boost their returns. However, this can also work in reverse, boosting losses. As an example, if you borrow £80,000 to buy a property worth 100,000GBP, your investment is 20,000GBP. If the property grows in value to be worth 110,000GBP after a year, your return o your investment is 50% (not 10%). The borrowing or gearing has boosted your investment growth. Of course, the reverse is true: if the property drops in value by 10,000GBP your investment has lost 50% in value. This demonstrates the risk you take with investment like buy to let. However, you can make great returns if you understand the nature of the investment.
This is the risk to your returns posed by the fluctuation of exchange rates between different countries, and is difficult to avoid. For example, if your investment is in US dollars, but made in UK pounds, your investment will fluctuation both by the underlying value, and be amplified by the changes in currency markets. This is made worse by the fact that many investments have an overseas element to them. Most FTSE 100 companies do not just trade in the UK, but are present in many countries. This adds some currency risk where you might not have considered it.
If you are considering retiring to another country in the not too distant future, you might want to think about taking your investments in the currency of that country. Otherwise you might find that the value of your investment is unduly affected by currency fluctuations when you come to draw on it.
Inflation risk Portafina Website
This is the risk that inflation will diminish the purchasing power of your returns. This is difficult to avoid, but there are products which link their income to inflation. Shares and commodities can be good hedges against inflation over time.
Interest rate risks
This is the risk that an interest paying asset loses value due to a change in interest rates. For example, some income orientated shares (like those in banks), tend to be interest rate sensitive, probably becasue their profits are affected by interest rate changes. Cash investments like bank accounts are also affected by interest rate changes.
Systemic and non systemic risk
This is the risk that the market goes against you. This is difficult to diversify away within an investment portfolio. Non systemic risk is the risk within a particular market; this can be diversified away using a broad spread of asset types.
This is the risk that a 3rd party will fail to fulfill its obligations (such as with the Lehman collapse). We can measure this risk using credit ratings, but this is not a perfect science.
This is difficult to predict, and often masks other problems. We often come across financial advisers who tell clients that they are close to the market and can time thier investments to achieve maximum returns. The reality is that this is very difficult to get right on a regular basis. The solution is to focus on the right allocation of assets based on probability of returns and volatility, and to rebalance an investment portfolio periodically to ensure that investments do not become too far away from the required level of risk.