What is the real risk? | The Finn Review
Today I would like to talk about that four letter word that is thrown around with investments all the time – RISK.
When determining an investment strategy, different types of risk usually get considered.
These different risks types are largely concerned with the chance that you may lose some of the principle of your investment.
What is the real risk?
I like to view risk in a different way. I see risk as the possibility of you not reaching your goals or objectives.
Why is this important? Well, because it is more tailored to your personal situation and it forces you to focus on what you need to do to reach your goals as that is ultimately the most important thing.
Your understanding and management of risk will ultimately decide whether you will reach your goal or not.
How is this put into practice?
In the current volatile investment market a lot of people want to be in cash because they believe that there is too much “risk” in other investments.
You may feel like you have very little risk in your investment strategy but if your investment goal requires you to get an 8% annualised return I would say you have a very risky strategy, as there is next to no chance of you reaching your goal.
The traditional method in financial advice of determining your risk profile was to get you to fill out a multiple choice questionnaire which basically determined how comfortable you are with investing.
I think this method is irresponsible to use as although it is important to take on your emotional feelings it does not take into account what you are trying to achieve. You may feel like you have a comfortable investment strategy but not realise that you are not on track to achieve your goals.
This philosophy can also be used to force you to reduce risk in your portfolio.
There a lot of people who I have come across who should not have lost the amount that they did in the GFC.
If they had focused on the goals they were trying to achieve they may have found that due to above market investment returns they were well on the way to achieve their goals. They could have and should have identified this and reduced the risk in their portfolios.
This is easier said than done though as human emotions of greed and the feeling that these types of returns are “normal.” This highlights the importance of having clear defined goals and regularly measuring how you are tracking to reach these goals.
All types of risk are important. But think of it in context of the risk of you not achieving your goals.
Examples of risk:
- Capital Risk – the chance that you will lose some or all of your invested capital.
- Inflation Risk – Losing purchasing power of your money. This could be a danger with a lot of people holding a lot of cash.
- Reinvestment Risk – The risk that when an investment matures that there aren’t as attractive investment options. This is currently occurring with term deposits.
- Liquidity Risk – the risk that when you need to access your investment that there is not sufficient liquidity. This results in you not being able to access your money or having to take a loss.
- Economic Risk – risk inherent in the economy as a whole. Economic events can have negative impacts on investment returns.
- Market Risk – risk of volatility in a market.
- Credit risk – the risk that the company or institution that you invest in does not have the capacity to pay the principle of interest amount.
- Interest rate risk – the risk that interest rates could change and the affect they will have on your investments.
- Income Risk – the risk that your investments do not provide you with adequate income to live off.
- Information Risk – the risk that the information that you are using to make financial decisions are wrong.
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Disclaimer: Information contained within this article is of a general nature. Do not be rely upon it when making financial decisions. Please consult a professional financial advisor or planner (like us!) before acting.