It’s been a volatile time on global investment markets, as shares and other assets are knocked about. At times like these it’s little wonder that more cautious investors decide it’s too risky to approach the start line.
No sensible person would take risks with their hard-earned cash for the sake of it, but the paradox of investing is that there’s no avoiding risk if you want to achieve financial security.
Risk vs volatility
Investing is an inherently risky business, but perhaps not in the way you think. While it’s common to hear people talk about volatility as a byword for risk, they are not the same thing.
In investment markets, volatility refers to daily price fluctuations. Risk, on the other hand, is the possibility that an investment will provide a lower return than expected over your time horizon or even a permanent loss.
Short-term volatility is only a risk if you need to sell investments after a big price fall. The longer your time horizon, the less important volatility becomes.
Here is a rundown of some of the main types of risk:
General market risk
This refers to the possibility that an investment will lose value because of a general decline in financial markets, due to economic, political, or other factors. Market risk can cause problems for investors who need to sell assets into a falling market, but it can also provide opportunities for bargain hunters.
This refers to the possibility of an economic shock or crisis that will cause panic selling, such as a debt crisis or a credit squeeze.
Interest rate risk
When rates are low investors borrow to buy shares and property, pushing up prices. When interest rates rise it’s more expensive to borrow to invest in shares and property so they tend to fall in value, while bank savings accounts and term deposits become more attractive.
Exchange rate risk
Exchange rates add another layer of risk when you invest in international markets or local shares with overseas operations. You can manage this risk to some extent by buying a hedged version of an overseas fund or shares in a local company that hedges its currency exposure.
Sometimes particular countries face political or economic upheavals that spook financial markets. The Greek debt crisis and the Chinese sharemarket crash are two recent examples.
This applies to particular sectors of a market or economy. For example, the spread of the internet is disrupting the business model of companies in the media sector, while low commodity prices have hit companies in the resources sector.
This is the risk that a company you own shares in turns out to be a lemon. Or your investment property is in the path of a new freeway.
That may sound like a lot of risk, but without accepting some degree of risk you are unlikely to earn the returns you need to keep ahead of inflation and achieve your financial goals.
The amount of risk you accept depends on your personal tolerance for risk, your investment goals and your time horizon.
If you are close to retirement, you may wish to reduce the overall risk of your portfolio to protect your capital. Even so, it’s still wise to keep a portion of your money in higher risk investments such as shares and property to produce the returns you need to last the distance.
You can’t banish risk entirely but the good news is that most risks can be reduced or managed with some simple strategies. Diversification across and within asset classes and geographic locations is the best insurance against the risk of poor performance in a single investment or market.
If you would like to discuss your risk tolerance in the context of your investment portfolio, don’t hesitate to call.