Wealth With Purpose

What you need to know to reduce your investment risk

To be a good investor, it is important to understand the concept of risk and how it can be managed and minimized. When it comes to investing there is a wide range of recognizable risks. The significance of these risks will vary from investment.

Before you invest your money in any investment it is important to take reasonable steps to assess the level of risk associated with that investment. We live in the days where people like to blame others when things go wrong. But as Christians it is vitally important that we take personal responsibility, after all we are stewards of God’s money and one day we will give an account of how we managed that money on his behalf.

These risks include:

1. Capital Loss – the risk that you lose some or all of your capital.

2. Opportunity Cost – the risk that the money would have been better off in an alternative investment.

3. Inflation Risk – the risk that inflation erodes the value of an investment over time. The impact of inflation is subtle but profound over the long term. Inflation is simply the observation of rising prices each year.

4. Interest Rate Risk – the impact that moves in interest rates have on the value on an investment. For example, most companies listed on the stock market carry some degree of debt. If interest rates rise, the cost of servicing the debt rises, and hence the profitability of the company falls. If the profits fall, them by default the share price should to. The opposite is also true. The same of course applies to property investments.

5. Tax Risk – the risk that changes in tax laws will alter the valuation of an investment. If the Government were to increase taxes on a particular revenue source, then the profit from that investment would fall, reducing its valuation.

6. Market Risk – the risk that a particular investment market (i.e. share market or the property market) loses value (e.g. a stock market crash). Many investments rise and fall seemingly in synchronised fashion. On days when stock markets have large falls or rises, the vast majority of listed companies move in the same direction. This is market risk.

7. Security Risk (specific risk) – the risk that a specific investment (a listed company or an individual) loses value. If a company announces the closure of a loss making factory, the

8. Credit Risk – is the risk of an organisation defaulting on its debt obligations. When you put your money in a bank, it technically (legally) becomes a liability of the bank. If the bank were to go bankrupt you would not be repaid. Credit analysts assess the risk that the bank would not be able to repay its customers. Likewise when a bank lends money to its customers to buy a home, it is their analysts that assess the credit risk of the borrower.

9. Liquidity Risk – is the risk of not being able to convert an investment into cash quickly. For example, from the time you make a decision to sell a property, to when it is sold and you actually receive the cash may be many months. This makes it an illiquid investment.

When the Global Financial Crisis of 2008 hit, one of the most significant issues was that many investments became very illiquid. In other words there were no buyers for those investments, and if there are no buyers then you can’t convert your investment into cash.

Other Risk Factors

When selecting investments you need to consider two other risk factors that impact your decision-making:

1) Timeframe to invest – how long you to you plan on holding the investment for? The shorter the timeframe the more important it is to hold liquid and safe investments (e.g. cash and term deposits) versus a longer timeframe where holding more growth orientated investments (e.g. shares and real estate) makes more sense.

E.G. A common question from people in their 20s who are saving for their first home, is where should they invest some of their deposit savings in order to get a better return than cash? To which my response is ‘when do you want to buy the home?’ They mostly reply in about 2 or 3 years, to which my reply was always the same ‘keep it safe, keep it liquid, keep it in cash’. Not the answer they were hoping for. But the problem is that if they invested the money in the stock market, then there would be no guarantee in 2 to 3 years that they would get back the same amount due to the significant volatility that the share market experiences.

2) Risk vs. Return – the higher the potential return of an investment, the higher the risk is that is generally associated with that investment. Holding shares and real estate should provide better long-term returns than having cash in the bank, because they involve more risk. Before making an investment it is vital to assess the risk of that investment against its potential return.

Trade Offs

All investing involves trade-offs. This is especially apparent in retirement. In retirement an investor must battle the need for growth in the investment relative to inflation (particularly over a long retirement) versus the need to protect the capital against loss, particularly in light of the fact that there is no longer any paid employment to supplement the income.

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