Why it’s important to understand investment risk

The difference between knowing about investment risk and truly understanding it can be marginal. However, it often pays big dividends being truly ‘invested’ in your investments, as it can potentially make or break your nest egg.

With some investments, it’s black and white. Those that pay off might be defined as good and the remainder might be classified as bad. Sometimes it isn’t always this clear cut. Some investments may underperform, based on expectations alone.

There might be a mismatch between the type of investment and the investor’s risk profile. For example, an investor sitting firm in the upper-right quadrant of the risk/return curve may be unsatisfied with a return of fixed interest nature even though their initial investment has technically paid off. On the other hand, a risk averse investor would usually aim to cover their principle in a high-growth style investment and work to gradually build on their return beyond that.

As such, it’s the inability to adequately understand risk that can prevent many investors from taking up new opportunities.

According to academic research on loss aversion, people get half as much enjoyment out of avoiding loss as to the thrill of a win – it might even be a 2:1 ratio. There has since been debate around that and the bottom line is, people really don’t like to lose money. What’s more, this loss aversion ratio usually blows out even further with investing. AARP, a peak body for retirement, conducted a study on this in the US around retirees and found the ratio could be closer to 5:1.

When investors don’t have a lifetime to make up for loss, they become that much more sensitive, and for good reason. However, there are ways to manage the likelihood of this situation to begin with. It all starts with understanding risk.

Types of investment risks

Investment risks come in all shapes and sizes. Generally speaking, there are three types of risks to consider before investing:

• The initial investment, or principle/capital loss.
• Lower than expected growth in the value of your investment.
• Lower than expected income return.

Diving deeper, these risks are a derivative of other risks that must be better understood. Namely, for Australian investors focused on equities, these other risks include market risk, inflation risk, interest rate risk and liquidity risk.

Market movements

Over the long-term, growth investments have traditionally outperformed defensive investments.

Most equities could be defined as growth investments, while cash and fixed interest are defensive in nature. Because share markets move through cycles and all investors have different time horizons, some investors may be better fitted to growth-style investments and others more suited to defensive.

Inflation and interest rates

Defensive investments often come attached with a different set of risks, more specifically, inflation risk and interest rate risk.
Conservative investments with lower rates of return may more greatly expose investors to inflation risk as there is a heightened possibility the value of the investment won’t keep pace with inflation. Inflation typically rises and falls slowly, however the risk remains when a fixed rate investment is held over the long-term, as is often the case. Likewise, investors may face a similar predicament with interest rate risk, as like inflation, as rates rise and fall over time too.

Interest rate risk applies to investments with a fixed rate of return that therefore becomes less attractive if or when rates rise, such as with term deposits. If these risks do materialise, they can make a significant difference to earnings.

Liquidity risk

Depending on the type of market the investment is trading or held within, liquidity risk can rear its head.
Liquidity risk may apply to select exchange-traded investments, as well as unit trust structures, property, alternatives, bonds and options. Some of these assets cannot be sold as readily as others, and investors may fail to shift them at a reasonable price.

Investments may also become illiquid during extreme market events such as a market correction, where most asset classes will downturn in tandem.

Articulating your appetite for risk

Investment firm, Morningstar, claims there are four standard investor types – conservative, balanced, growth, and high growth. Naturally though, some investors fall outside these parameters and dance to the beat of their own drum.

Generally speaking, your appetite for risk will depend on your life stage.

Some investors might be more willing to grow their savings over the long term, while others will be focused on drawing a regular income. Therefore, the former are likely to be more interested in growth investments, while the latter will look for income producing investments.

Life stage can usually be defined by age and relative proximity to retirement. This will determine whether you’re investing for the short term (1-3 years), medium term (3-5 years), or long term (more than 5 years).

However, as an example, a couple in their early 30s saving for their first home might be just as adverse to risk as an older person nearing retirement. When it comes to appetite for risk, age doesn’t override life stage by rule.

It can be more difficult to recover from a negative financial event after a certain age because of the length of an average market cycle.

As famed investor John C. Bogle said, “if you have trouble imagining a 20 per cent loss in the stock market, you shouldn’t be in stocks”. As we age, investments that sit towards the bottom left quadrant of the risk/return spectrum may become a more important part of the asset mix to provide a buffer.

One thing to keep in mind when articulating your appetite for risk is that retail and sophisticated investors often set about building their portfolios in different ways. That can be to the detriment of retail investors.

Some investors are more inclined to follow a bottom-up strategy. They select a manager or fund, or start with a specific company in mind, and pay little regard to their overall portfolio construction as a whole. They will pick the investment first and then work up to validate the trade.

Evidently, this approach doesn’t always factor in the investor’s overall objective or risk profile. Listing the drawbacks of this strategy, US investment firm Charles Schwab says preconceived notions may then be hard to shake. The strategy also ignores larger economic influences that may impact the investment. Conversely, top-down investors start with the big picture and work their way down to find a particular investment. They settle on their risk profile, then decide on asset allocation, and then investments they deem fit. For instance, they work to get the cash balance right according to their needs, the international to domestic equities ratio aligned to their risk appetite and then determine a mix of alternatives that suit them best.

Charles Schwab says this strategy may take more time and energy, and mean that investors miss out on ‘bargain’ investments in eliminated areas of the market. However, starting with no preconceived notions, and focusing on strong sectors overall, may produce more diverse results.

Managing risk through diversification

Diversification should be the default mode for most investors. Investing in this fashion can help lower your risk because different asset classes generally perform well at different times.

For instance, some assets may perform well when the Australian dollar is rising, whereas others may do better when the Australian dollar is falling. These norms may not even apply to an asset class as a whole, but instead specific investments within that asset class (e.g. individual shares on a single share market).

As such, it may be considered poor form to keep all of your eggs within the one basket, and you may suffer the consequences through even poorer returns for doing so. By placing your money across a number of different asset classes and investments, the positive returns you receive from one investment may offset negative returns from another.

It may be appealing to put everything into the best performing asset class, or what appears to be the best single investment by analysis. However, often in these cases, gains could more easily be wiped by a correction dictated by economic or investment cycles, which are typical by nature.

On balance, the best way to manage risk is through diversification.

Looking to learn more about managing risk within your investment portfolio? Our Managing Director Philip Ryan’s provides an inside look at his own investment strategy.