Few terms in personal finance are as important, or used as frequently, as "risk." Nevertheless, few terms are as imprecisely defined. Almost universally, when financial advisors or the media talk about investment risk, their focus is on the historical price volatility of the asset or investment under discussion.
Advisors label as aggressive or risky an investment that was prone to wild price gyrations in the past. The presumed uncertainty and unpredictability of this investment's future performance is perceived as risk. Assets characterized by prices that historically have moved within a narrower range of peaks and valleys are considered more conservative.
Unfortunately, this explanation is seldom offered, so it is often not clear that the volatility yardstick is being used to measure risk. Before exploring risk in more formal terms, a few observations are worthwhile. On a practical level, we can say that risk is the chance that your investment will provide lower returns than expected or even a loss of your entire investment. More to the point, you are concerned about the chance of not meeting your investment goals. After all, you are investing now so you can do something later (e.g., pay for education, retire comfortably).
Since every investment carries some degree of risk, it makes sense to understand the kinds of risk as well as the extent of risk that you choose to take, and to learn to manage it.
What you probably already know about risk.
Even though you might never have thought about the subject, you are already familiar with many kinds of risk from life experiences. For example, you know intuitively that a home in an area that has a high crime rate will likely cause a drop in the market price of that home. You must be mindful of these and other kinds of risks going forward. Volatility is a good place to begin, however, as we examine the elements of risk in more detail.
Volatility - why is it risky?
Although past performance is no guarantee of future results, historically the negative effect of short-term price fluctuations has been reduced by holding investments over longer periods. But counting on a longer holding period means that some additional planning is called for. You should not invest funds that will soon be needed into a volatile investment. Otherwise, you might be forced to sell the investment to raise cash at a time when the investment is at a loss.
Other types of risk
Here are a few of the many different types of risk:
- Market risk: This refers to the possibility that an investment will lose value because of a general decline in the market, due to one or more economic, political, or other factors.
- Inflation risk: Sometimes known as purchasing power risk, this refers to the possibility that prices will rise in the economy as a whole, so your ability to purchase goods and services would decline. For instance, your investment might yield a 6 percent return, but if the inflation rate rises to double digits, the invested dollars that you got back would buy less than the same dollars today. Inflation risk is often overlooked by fixed income investors.
- Interest rate risk: This relates to increases or decreases in prevailing interest rates and the resulting price fluctuation of an investment. If you need to sell your investment before maturity, you run the risk of loss of principal if interest rates are higher than when you purchased the investment.
- Default risk: This refers to the risk that a tenant will not be able to pay their rent or cause damage to your investment.
- Liquidity risk: This refers to how easily your investments can be converted to cash. Occasionally, the foregoing definition is modified to mean how easily your investments can be converted without significant loss of principal.
- Political risk (for those making international investments): This refers to the possibility that changes in foreign governments or politics will adversely affect the financial markets there or the companies you invested in.
- Exchange risk (for those making international investments): This refers to the possibility that the fluctuating rates of exchange between AUS and foreign currencies will negatively affect the value of your foreign investment, as measured in AUS dollars.
The relationship between risk and reward.
In general, the more risk you're willing to take on (whatever type and however defined), the higher your potential returns, as well as potential losses. This proposition is probably familiar and makes sense to most of us. It is simply a fact of life--no sensible person would make a higher-risk, rather than lower-risk, investment without the prospect of a higher return. That is the trade-off. Your goal is to maximize returns without taking on more risk than you can bear.
Understanding your own tolerance for risk.
The concept of risk tolerance is twofold. It refers to both your personal desire to assume risk and your financial ability to endure risk. It also assumes that risk is relative to your own personality and feelings about taking chances. If you find that you can't sleep at night because you're worrying about your investments, you've assumed too much risk. Your financial ability to endure risk has more to do with your age, stage in life, how soon you'll need the money, and your financial goals. If you're investing for retirement and you're 35 years old, you can endure more risk than someone who is 10 years into retirement, because you have a longer time frame before you need the money. With 30 years to build your retirement fund, you have the ability to withstand short-term fluctuations in hopes of a greater long-term return.
Evaluating risk - where to find information about investments.
You should become fully informed about a product before you invest. There are numerous sources of information about investment products. You can find information in third-party business publications and websites, as well as annual and other periodic reports. Third-party business and publications can provide previous sales reports, neighbouring sales reports, area statistics, news stories, and information about an area. This is some of the information that you can gather to help evaluate the risk of a particular investment.