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Seed Weekly - Considering all Investment Risks

While virtually all investors acknowledge that investing involves taking on risk, most investors do not know or take the time to clarify these risks and also to understand the interplay. For example, an investor may be overly concerned about taking on too much market risk and when reducing this risk too much, inadvertently takes on too much longer term inflation risk with a more conservatively constructed portfolio.

It ultimately all comes down to how you define risk and on which aspect an investor places the highest value. A good definition of risk is: “The chance that an investment's actual return will be different than expected because risk includes the possibility of losing some or all of the original investment.”

A typical investment risk pyramid may look something like this, but this is too simplistic a view of the actual risks that an investor faces.

Firstly, for most investors is the mortality or actuarial risk. This is the risk that having saved up a quantum of savings over your productive life, into your retirement years you run out of savings as you live longer than expected, drawing down too quickly on your accumulated savings.

Then there is inflationary risk. Where an investor aims to achieve a rate of return of at least the inflation rate over time from his investment portfolio, there is a risk that his investments will not achieve this return because of inferior performance or where inflation becomes rampant and at worst hyperinflation.

Ironically in times of very high inflation and hyperinflation it is the relatively "safe" investments such as fixed income investments that are the highest risk investments, while the typically understood “risker” investments such as shares, are the lowest risk, in that they have a higher probability of preserving purchasing power.

Once an investor has considered these two main risks, he needs to consider the following, which individually and collectively impact on the mortality and inflationary risk:

Market risk is the risk that the value of your investments fluctuates and at worst, in a major market decline, results in permanent loss of the original capital invested. This is the one risk that many investors fear more than any others, often without having properly considered mortality and inflationary risk.
• The risk of default is one where an investor expects a certain guaranteed return typically from a fixed interest investment such as a bond issued by a government or a corporate and before maturity of the fixed investment, the issuer defaults, with the investor not being fully paid out and in the worst case scenario receiving nothing back.
Liquidity risk is the risk that when the investor wants to convert the investment into readily available cash he is unable to do so for various reasons. Typically speaking less liquid investments, for example private equity, should generate higher returns that a money market investment. Part of the reason for generating this higher return is the higher liquidity risk.
Interest rate risk is risk generally associated with an investment into fixed interest investments. While these investments are typically understood to be in the lower risk category, where an investor has, for example, invested into a 10 year bond yielding 8.5% pa, the risk to the investor is where interest rates move up and now similar bonds yield 10.5%. In such a case the investor will suffer capital loss.
• Another risk each investor faces is political risk. This is because governments have far reaching ability to implement legislation that can severely impact companies, taxes, and property ownership rights for example. While certain governments around the world are seen to be “investor friendly” there are many that have a far more inconsistent approach to legislation, increasing this risk.
Currency risk arises due to a global economy where one currency floats against another. Being exposed to just one currency is itself a risk, but where an investor converts a portion of his investment into another currency, he runs a currency risk should that currency in which he invested decline on a relative basis. South Africans have typically benefitted from currency risk, but there have been long periods of time where the Rand has appreciated and then this risk is more fully appreciated.

When looking at risk in this context, it is less important and indeed less meaningful to try and ascribe a single number to risk, such as standard deviation or price volatility. It is far more meaningful to consider each risk and its potential impact on the investors financial planning and the total portfolio.

Kind regards

Ian de Lange

021 914 4966

Tue, 15 Apr 2014- 12:33

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