Understanding and Managing Investment Risk

Risk is an integral part of investing as all investments entail some element of risk and there is a close positive correlation between risk and return. Even if you don’t invest and leave your money in a bank account you still face inflation risk, the risk that prices will rise by more than the return on your funds, thereby eroding their purchasing power. It is important, however, to understand the risks you are taking when making an investment as learning about the risks that apply in different situations and knowing how to manage them can help you avoid unnecessary setbacks. In this post we put the focus on risk with an explanation of some of the risks you will encounter while investing and a discussion of ways to manage them.

When we refer to risk in an investment context, we usually mean volatility of returns, where return is measured by the change in portfolio value. Higher risk involves greater variability in returns while lower risk equates to more stable returns. Risk can also mean exposure to loss with respect to investments where there is the possibility you could lose some or all of the amount invested. When we refer to risk in this post, we can mean either volatility of returns or exposure to loss, depending on the context in which the term is used.

As an investor, it is necessary that you understand investment risk regardless of how your portfolio is being managed. If you are investing in a portfolio that will be professionally managed, you should ensure that your risk tolerance is clearly communicated to the investment manager for developing the portfolio investment strategy. You should note that there are two main factors that determine your risk tolerance, your attitude to risk and your capacity for loss. Attitude to risk refers to how much risk you are prepared to take with your money and is determined by your personal characteristics. Someone who is risk averse, for example, would have a lower risk tolerance than a risk seeker. On the other hand, capacity for loss relates to your ability to cope with declines in the value of your investment and depends on your financial circumstances. If a material decline in the investment portfolio would adversely impact your standard of living or hinder your ability to achieve your financial objectives, then your capacity for loss would be low. Capacity for loss is also determined by your investment horizon, where a shorter horizon usually means a lower capacity for loss as there would be less time to recoup losses in the portfolio. Most investment advisors have questionnaires that are used to gauge your level of risk tolerance which they consider in managing your portfolio. You can check your risk tolerance using KSBM’s questionnaire. Moreover, if you are now starting to invest, you should consider erring on the side of caution by taking less risk to avoid negative surprises early in the process. You can always increase your risk exposure after gaining experience and knowledge of how the market works.

Meanwhile, there are different types of risks that can affect your investments. If you are investing in stocks, the main risk you will face is market risk, also known as equity price risk, which refers to fluctuations in the market value of your equity portfolio as share prices change. Market risk arises from the factors that drive equity values, for the market overall as well as for individual companies. In assessing market risk for stocks, you will have to consider expectations for the economy, interest rates, government policy and inflation. Furthermore, company size and industry dynamics are other factors to take into account in your market risk assessment for equity investments. This is primarily due to the fact that shares of larger, more mature companies tend to experience lower price volatility than that of smaller firms, while share prices of companies in industries with higher business risks tend to fluctuate more widely.

Additionally, market risk can impact investments in fixed income securities when you invest in a fixed rate debt instrument and the instrument maturity date does not match your investment horizon. In this context, market risk is referred to as interest rate risk and results from fluctuations in the value of the investment due to changes in level of interest rates. Where your investment horizon ends before the maturity date of a debt instrument that is held in the portfolio, you will have to sell the security at a price that may be different from your purchase cost. The price of fixed income securities varies inversely with interest rates so if rates rose after the purchase, if you had to sell at that time you would likely receive less principal than what you paid. The opposite would apply if interest rates fell, with the size of any price change depending on the remaining term to maturity of the instrument. When interest rates change, the percentage change in price is greater for longer-dated bonds than short-dated ones, which means that bonds with long maturity dates have higher market risk.

Nevertheless, the primary risk you will face when investing in debt securities such as bonds is credit risk, i.e., the risk that the issuer of the bond may be unable to repay principal and interest. This is also referred to as the risk of default and can be assessed using credit ratings, which is a credit rating agency’s assessment of the probability of default of a borrower. Credit ratings are usually assigned at the debt issuer or company level and cover the borrowings of the entity. Within the issuer’s debt structure, secured debt would be rated higher than unsecured debt which would in turn be rated higher than subordinated debt. Credit ratings can be divided into Investment grade, where there is a low probability of default, and speculative grade where the probability of default is higher. When relying on credit ratings it is important to check the date of the last update as sometimes credit rating agencies may not update an entity’s rating in a timely manner. Moreover, before investing in a debt instrument that is not rated, you should have a credit assessment done to determine the level of risk you are taking and to ensure the return offered is commensurate with the risks.

Another key risk you will face while investing is liquidity risk. This is the risk that you may not be able to sell an investment at fair value within a short period of time. Liquidity risk is less of a concern with public equities, although there are some illiquid stocks with low trading volumes, but can be an issue with bonds where the secondary bond market is not well developed. Bonds issued in Trinidad & Tobago, for example, are generally illiquid so when investing in such bonds you need to be comfortable that your investment horizon extends beyond the maturity date so you will not have to sell.

Having an awareness of the various risks described above would not only assist in guiding your investment decision making; but should also prompt you to consider applying the following risk mitigation strategies where appropriate:

  • This is a proven method for reducing risk that involves holding a variety of assets in your investment portfolio that are not closely correlated. You can diversify by investing in different asset classes as well as across different names within an asset class. Diversification benefits are achieved when security prices move in opposite directions, resulting in smaller overall fluctuations in portfolio value.
  • Due diligence. This simply means checking the facts and asking the right questions before making a decision, whether you are relying on an investment expert or managing your own investment portfolio.
  • Sometimes the best approach is to say “no” to an investment when you are not comfortable with the risks or believe that the return is not adequate for the risks involved.
  • Long investment horizon. Starting early and staying invested over a long period would minimize the impact of volatile periods on your portfolio. Also, consistently investing small amounts at regular intervals is usually a better strategy than trying to “time the market” with large investments.

While this post cannot cover all the possible risks an investor faces when building and maintaining an investment portfolio, it should have given you an insight into what to look for as you go through the process of investing, and also raise the awareness that investing requires careful contemplation to successfully navigate the risks involved.

 

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