The only certainty is uncertainty.
“If you stay in bed you are in danger of getting bed sores. If you lie down in the middle of the road you are likely to get run over. You should walk on the path but still watch out for the odd skate board!”
There is no such thing as “risk free”. Even government and banks can or have the potential to default as the events of 2008/9 have taught us.
The four interrelated personal risk issues are:
- Risk tolerance: the amount of risk that you are comfortable taking, or the degree of uncertainty that your are able to handle. It can vary with age, income, financial goals and extent of your current wealth.
- Risk perception: is the subjective judgment we make about the characteristics and severity of risk. We tend to have a strong bias to take whatever occurred recently and extrapolate it indefinitely into the future (markets going up will grow to the sky, and markets going down are falling to $0), we often fail to keep events in perspective.
- Risk required: is a return on investments that is required to fulfil your goals. Your Goals may require a level of risk that exceeds your risk tolerance and you will need to find your own balance between reduced Goals or increased risk. Life is full of compromises!
- Risk capacity: your ability to absorb falls in the value of your investment. If any loss of capital would have a materially detrimental effect on your standard of living, this should be taken into account in assessing the risk that you are able to take.
The real challenge is to have realistic expectations and understand the range of risks you could be exposed to. It is important to understand how both fear and greed distort good decision making.
As advisors it is our responsibility to exercise what is called fiduciary care. We need to understand exactly what you are trying to achieve (Your Goals), to work with you in line with your Investor Profile (Defensive, Low Growth, Medium Growth, Medium High, Aggressive). This is why a Financial Health Check should be the starting point. We will take into account a whole range of factors including your time horizons and the following risks:
Doing Nothing Risk: If you ignore what is happening in your own life and in the world and do nothing you are failing to take into account what is actually happening and the consequences. Inflation is an example. It can “steal” your savings. Those that fail to plan, plan to fail!
Inflation Risk: If the inflation rate exceeds your after tax returns then you are going backwards! You are losing your buying power. This often happens to those who exclusively remain in cash and / or fixed interest.
Market Risk: An investment will participate in a particular investment sector e.g. Domestic Share Market and often, regardless of the actual holding, will experience the impact of market sentiment, both positive and negative. This can be driven by either economic factors or human behavior and is often a combination of both. Some funds use technical investment tools to manage this.
Specific Risk: If funds are placed into an asset which is not diversified within itself then the outcome will be dependent on that one placement’s performance. Grouped Investment Funds / Mutual Funds seek to mitigate this by diversifying the risk.
Currency Risk: If investments are held outside of the country in which you live and in which you intend to use these funds then the differential in currencies can have significant impact on the purchasing power of your portfolio. Hedging strategies are a way of managing this. If everything is hedged back into NZ$ then there is the risk of the NZ$ which can be quite volatile. Gains can be made when the NZ$ weakens.
Default Risk: This occurs when the issuer of a security is unable to repay a loan. Research Houses / Rating Agencies seek to quantify the probability of this happening. The Global Financial Crisis (GFC) of 2018 showed that they can get it wrong!
Sector Risk: There are times when one sector is depressed while the others are buoyant. Diversification over different asset classes seeks to mitigate this.
Liquidity Risk: Not all investments are accessible at anytime and will be dependent on a variety circumstances. Do not asume that all of your funds, once in vested, are accesible. Liquidity has to be managed in line with your circumstances.
False Confidence Risk: Assumption that we know everything about the future and make decisions that are have no future flexibility.
Duration Risk: Locking into a long term investment based on current economic assumptions when these assumptions can change. e.g. locking into a low interest rate Fixed Interest Security for 10 years means the value of the Bond, if tradable, will go down if not held to maturity if interest rates rise. In addition there is the missed opportunity of higher rates in the future. Few can see 10 years ahead!
Leverage Risk: When funds are loaned to increase an investment both loss and gain are magnified. Leverage needs to be used in a controlled way and is not suitable for everyone. It is also called gearing.
Risk Management Strategies
“Do not put all your eggs into one basket”
Those who diversified over a wide range of finance companies in 2008-10 had a limited view of diversification and were effectively exposed to one market sector. 50+ Finance Companies failed with defaults of $6 Billion!
Diversification over Asset Sectors.
This maxim can be applied to both Asset Allocation (How much you invest in: Cash, Fixed Interest, Property, Equities and Specialities) and the underlying investments used in each of your Asset Sectors.
It is beneficial to spread your investments over a range of assets. In different years often a different asset is the best-performing one. It is difficult to predict which Asset Sector will perform best in any given year. Trying to pick the best Asset Sector and knowing when to move to another is speculative.
It is prudent to following a consistent plan which weights your exposure to a range of Asset Sectors in line with your Investor Profile. Historical analysis of each Asset Sectors behaviour determines how much exposure you should have to each sector. Your Investor Profile will been aligned with a Strategic’s Asset Allocation (the long term view).
Tactical adjustments may be made based on what is actually happening now e.g Monday is washing day but as it’s raining we will make a tactical decision to wash on Tuesday! Reality has priority over theory.
A mixture of Asset Sectors is more likely to maximise returns and minimise risk providing you with the best opportunity to reach your Goals. The past is not a guarantee of the future but it can be a guide.
Diversification over / within Investments.
Investment diversification within your Asset Sector compliments Asset Allocation. While a portfolio can be diversified over a range of Asset types it can also be diversified over the range of investments types. The intent is to reduce your exposure to the specific risk of any one investment.
Strategic will seek to manage your portfolio within the criteria set and will seek to give you exposure to Investments that are performing in the top quartile and to adjust your Asset Allocation to meet current economic conditions whilst maintaining your Investment Profile. Most investments are medium to long-term. Fixed Interest 1-3 years; Equities 5-10 years; property 5-7 years. Early redemptions can compromise your strategy. Where possible Strategic seeks to limit exposure to any one investment to a maximum of 10%
Returns will always be dependent on current economic conditions and no absolute guarantee is possible.
A well designed portfolio will seek to optimise returns and minimise risk.