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What you need to know about risk

Risk is a rather more complex and nebulous concept than many people realise. To many people, risk is a dramatic 1987 or 1929 style stock market crash, and the usual way that investors seem to handle this one is by jumping out of windows. To others, risk is about buying a stock and then losing all of your money because of dishonest accounting and stock manipulation.

If you perceive either of these to be the dominant risks of investment, then you probably think of investment as a form of gambling. This is built in to the language of speculation, people refer to “playing the stock market”, and they like to “take a flutter”. If you are a person that looks at the stock market as a place for laying bets, then you probably will have about as much success at it as any gambler.

There is only one meaningful measure of risk:

Risk is the chance of not having enough money when you need it, to buy something important.

Clearly that is a much broader definition of risk, it contains many factors. What follows is a general summary of what risks you need to worry about.

Having insufficient retirement savings to live comfortably in your old age.

This risk is obviously a very important one. You may have insufficient retirement funds for all sorts of reasons. You may have lost money on investments, and I’ll get to that possibility shortly, but most people have insufficient funds simply because they failed to invest enough in the first place.

What many people fail to appreciate is that a self funded retiree must go for around 20 years without a pay check. Think about how much money you would need to spend each year and then multiply that by twenty. It is usually a huge number.

But what about investment earnings? Can’t you get away with having much less and rely on investment appreciation to get you out of trouble? Of course you are going to get a return on your investment over time, but before you get to pocket any of that you have to take into account inflation, taxes and investment related fees first. After taking out of all of these there should be at least some growth, but probably in many cases not enough to make a really serious dent in the amount you need to save annually.

So if you are ten years away from retirement, you have ten years to save up enough money to last twenty years. This often comes as a tremendous shock to people, particularly those that think the 9% of salary paid by their employers as government mandated compulsory super contributions is actually going to amount to much. The figures vary depending on what assumptions you feed into the calculator, but according to calculations run by a variety of financial services groups, if an 18 year old has 10% of his or her salary paid into super each year until his 65th birthday, that person will have just enough money that he or she probably won’t be entitled to any social security assistance, but an income only a fraction of pre-retirement salary.

There are of course two ways to reduce this risk. First of all you can invest more money, secondly you can try to get a higher return from your investment. One will cost you in terms of hurting your living standards right now (less money to spend today because you are putting your money into a savings plan), the other will cost you in terms of having to take a higher market risk. Eat well or sleep well, you have to make a choice, but don’t take too long about it because the longer you wait the more you’ll have to invest later, and the higher return you’ll need.

Mismatch risk

Mismatch risk is a risk that is completely specific to a specific investor. An investment that would be highly appropriate for one person could be a complete disaster to someone else. Whether an investment is appropriate depends on your specific spending requirements and other obligations, time frame attitudes and abilities.

A 20 year old should in almost all cases invest his or her superannuation money mostly in growth assets like shares and property. Cash and bonds simply don’t have the tax efficiency and growth potential to make them worthwhile holding as a very long term investment. Over the course of a couple of decades an investor in growth assets usually winds up so far in front of a conservative investor that the decision to be overly conservative can only be seen as a complete disaster. It is all very well to fear the stock market, but a young investor can’t touch his super for 40 years anyway, so there is definitely merit in looking to the long term.

A much older investor usually needs to see things differently. In this case there is much less time to rely on the long term gains from shares and property, such an investor necessarily needs to take a shorter term view. In this case the bias will be toward relatively stable portfolios that emphasise a mixture of income and steady capital growth, as opposed to a fairly volatile high growth strategy.

Even investors that are the same age may have different needs, particularly with regard to the tax treatment of some investments. There are social security implications of many strategies that affect some people, and not everyone has the same goals with regard to estate planning.

The best way to overcome mismatch risk is to get a good investment education, or find a suitable financial adviser. An even better remedy of course is to do both, looking for advisers with more on their minds than just commissions.

Market risk

Market risk is the risk that everyone thinks of. It is the risk of a market “crash”, or less dramatically lesser falls that occur on a very regular basis.

It is unavoidable that growth assets tend to be volatile. Volatility is caused by traders and investors revising their estimates of future profits in response to new economic data, the outlook for inflation, currency movements, commodity prices and more. Each of these factors are unpredictable, yet they can make a huge difference to prices. In addition, there are “psychological” reasons behind stock movements, which relate to optimism or pessimism in traders as a group that may at times be even more important than “hard” economic data.

To compensate for these uncertainties, investors generally avoid paying too much of a premium for stocks with uncertain futures (with notable exceptions, like Internet stocks in the late 1990s, as well as a number of similar episodes). Investors in shares are purchasing the right to participate in profits generated by businesses, this is of course what investment is all about, as opposed to speculation which is about trying to guess the short term movements of markets so you can make speculative profits out of other traders. Just like a business owner, overall a well diversified shares investor can expect good returns over time. Investors are rewarded for buying assets when the future is uncertain by higher returns than can be taken from more predictable assets like cash and bonds.

Even though investors are generally compensated for taking on this uncertainty, it does manifest itself as real risks. On top of the very famous price drops like 1987 and 1929, there have been a number of less famous falls over the years.

In fact looking at a chart of the stock market going back 100 years there seems to be a fairly good sized drop about once a decade. There is no reason to believe that the stock market operates on any kind of fixed time cycle, ten years or otherwise, and thus there is no justification in counting the number of years such a fall may be overdue. But nevertheless if very long term charts say anything about the future it is entirely reasonable to expect that long term stock market investors can look forward to experiencing a few large (50%) drops in their lifetime.

It would be a mistake to think that you have any way of avoiding these falls. If God himself came down and told us the day the market would crash the prophesy would not come true: everyone would sell out a week earlier and the crash come too early. There is no way to predict a market drop in advance, and it is a mistake to sell shares after such an event. Thus, you need to accept as a condition of entry that as a long term share market investor you will have your portfolio drop in value from time to time when these falls hit.

If you can’t handle the idea that markets are volatile, the only remedy is not to invest in volatile investments. Put your money in cash management trusts instead. You will pay dearly for this because cash management trusts give lower long term returns than the stock market, but it is that whole eat well or sleep well compromise again.

Given that markets are volatile, it is essential not to put yourself in a position where such volatility has a chance to cause you actual financial harm. If you still have significant time before you need to cash out from your investment you can afford to accept volatility, if not you need to do something about it.

For short term goals, you will necessarily need a more conservative portfolio. There is nothing wrong with using cash management trusts and capital guaranteed investments for financial goals only a few years away.

The only remedy for market risk is having a sufficiently long term outlook that short term volatility doesn’t matter much. You can also invest across a variety of asset classes, though this can’t reduce risk entirely.

Security specific risk

When buying direct investments like the stocks of specific companies, properties, bonds and mortgages, there are extra risks above that you experience when dealing with entire asset classes or diversified funds.

If you are buying shares or corporate bonds, there is the risk that the company is going to run into financial difficulties, or at the very least make less profit than the market was expecting them to. These extra risks are added on to market risk, which makes an individual security inherently much more risky than a portfolio of them.

There are two cures for security specific risk, but only one of them is reliable. The first cure is hard work and detailed analysis. I recommend you use this strategy in addition to the second one, but bear in mind that it is a lot harder than it seems.

The second way to reduce security specific risk is to diversify your portfolio. Some of the securities you buy will do better than you expect them to, some will do worse. Overall many of the security specific risks will cancel out. The more you buy, the less important security specific risk becomes, and the more the portfolio comes to exhibit risk characteristics in line with the general market.

Interest rate risk

Interest rates affect more than just pensioners with term deposits and mortgagees, they have an effect on all investors.

All financial assets can be valued by taking all cash flows they produce for an investor and “discounting” these back to a present value by the rate of return investors expect. This all sounds more complex than it really is, at least from the point of view of a passive investor, because analysts take all of this into account when they value shares.

Although the average investor rarely needs to worry about discounting cashflows, these investors still will feel the effect of interest rate changes. When interest rates rise, or when analysts expect them to rise, the value of every financial asset, from shares to bonds to real estate and every alternative asset class will fall. This is because when interest rates rise the return investors can get “risk free” from cash investments goes up with it, as investors expect some kind of “risk premium” for buying risky assets they will have to reassess the value of these assets.

Take the example of a 10 year bond with a face value of $10,000, that pays a fixed coupon of 7% of the face value, ie $700 a year. If interest rates are now 7%, and nobody expects interest rates to change, and this bond is considered “risk free” (ie the bond seller has flawless credit and there is a 100% chance of the bond payments being made in full, on time, including the final payment of the coupon), then this bond will trade for $10,000 on the bond market.

If interest rates were to suddenly rise to 14%, then investors would be able to buy a brand new bond that pays 14%, they would expect a substantial discount for buying the 7% bond so they would get the same return. Plugging these values into my financial calculator I find that the present value of a bond that pays annual coupon payments of $700 for ten years and then a final payment of $10,000 would be worth $6,349 on the open market if interest rates are 14%. Another couple of key presses I find that if interest rates were 4% this bond would now trade for $12,433, which as you can see is a $2,433 premium to the face value of a $10,000 bond. If you are interested in knowing how to calculate these yourself I wrote an article on time value of money in my investment FAQ, see the links section for the web address.

So it is clear that rising interest rates can lead to investors making a capital loss on investments. This comes as a surprise to some people, particularly bond investors that assume that bonds are low risk. Bonds are low risk compared to growth assets because the future cash flows aren’t usually in doubt, you can safely assume for most investment grade bonds that the future cash flows will equal the coupons plus the repayment of the face value of the bond on maturity.

Cash flows for growth assets like shares and real estate are less certain, in these cases a wide variety of factors will influence profits, it is because of these uncertainties that investors in these assets err on the side of caution and more heavily discount the cash flows (which in plain English translates to them refusing to pay too much for this pig in a poke). Bonds are less risky than shares and property, but they still can bring about losses, 1994 in fact was a famous year because a rapid increase in interest rates of around 1.5% in six months actually caused a crash on the bond market.

Interest rate changes have pretty much exactly the same effect on all assets, shares, real estate, bonds and alternative asset classes. Other asset classes will react to interest rate hikes just as bonds do (though many factors influence other asset classes and make the relationship less obvious), so in fact every investor in every asset class is vulnerable to rises in interest rates, though some more than others.

There isn’t really any way to counter interest rate risk, unless you want to put all of your money in very short term cash investments. Even if you do this though, you still have the opposite risk, that interest rates will fall and you’ll miss out on the capital gains that investors in longer term asset classes experience.

Another precaution is that investors need to be careful when they borrow money for investment purposes. There are many people that promote the idea of buying as many investment properties in a short period of time as possible, borrowing against existing equity. This is fine if interest rates stay where they are, but it can be a complete disaster when interest rates rise or demand for rental accommodation slackens, as it does from time to time. In this case the investor may end up with huge negative cash flow, and if this is unsustainable the investor will need to sell some properties in a hurry. Of course many people may be forced to sell at that time, so this investor will need to sell into a “buyer’s market”, and that is how people lose their shirts in real estate. To get around this make an assumption before borrowing any money that interest rates are going to rise substantially, and only borrow as much as you could afford at the higher rate. Don’t make the common mistake of assuming that just because a bank is willing to lend you the money that you should do so.

Liquidity risk

Liquidity risk is the risk that you will need cash quickly, but you can’t get it because your money is tied up in assets that either can’t be sold quickly or at all. The classic example of this is with real estate, which takes a long time to sell.

What if you lose your job? What if a large unexpected expense is incurred, such as a medical emergency, the birth of a child or needing to travel to attend a very important event? Apart from unexpected expenses, what about unexpected opportunities? There are a lot of times when it can be very important to be able to get cash in a hurry.

Leave some money in reserve, a good place is a mortgage offset account or redraw facility. Alternatively if you don’t own a house at least a few month’s income should be kept in a cash management trust. If you are employed, and rely on your income, income protection insurance is also highly recommended. If you just want very basic cover you can get IP cover cheaply via “group rate” policies offered through some superannuation funds.

Another caution is that investors should have some of their assets in ordinary money as well as superannuation, because getting your money out of super before you reach your preservation age is difficult, expensive (you usually pay higher lump sum tax rates) and in some cases impossible as the conditions of release are quite stringent – and by the way, those “Superrelease” guys that claim to have found a loophole for early access of super are a scam, and are presently under investigation by the Australian Tax Office and ASIC.

Credit risk

Credit risk is the risk that someone you have lent money to will not be able to give it back. This applies not only to the obvious situations such as loans to a specific person, but for any debt instrument such as a bond or debenture, some cash management trusts and also shares, which can go broke from time to time.

To minimise credit risk you need to be able to assess the ability of a borrower to repay a loan, or you need to invest in partnership with someone that does this for you. There are companies such as Moodys and Standard and Poors that provide credit ratings for corporate and government debt, and their reports are easy enough to get hold of, but you’ll have more difficulty getting credit data on individuals.

As a general rule of thumb, if someone wants to borrow money and is willing to pay a high rate of interest, it is because a financial institution has already knocked back the application for finance on the grounds that the loan is too risky. The first call for most people to apply for a business loan will always be a bank, because banks lend money at the lowest interest rate. If an investor is forced to borrow at rates higher than bank interest it means the bank turned them down.

Recent scandals in the finance broking industry brought this issue into the public eye, with numerous examples of risk intolerant investors lending money to property developers and entrepreneurs found to their detriment that sometimes assets can be worth less on the open market than a borrower says they are worth, despite certificates from valuers and others. This is a place where only more sophisticated investors should venture, yet ironically it is usually less sophisticated retirees that lend money through these finance brokers, seeking higher returns than can be offered via mainstream cash management type accounts.

The remedy to credit risk is the same as the remedy for security specific risk, do your homework and when in doubt diversify. Another rule to remember is that the higher the return being offered, the more risky the offer is likely to be. A mortgage more than just a couple of percent higher than the going rate from a bank is going to be quite risky.

Currency risk

Currency risk is the risk that currency movements will occur that are adverse to an investor or borrower.

There are two risks: that the Australian Dollar will fall substantially relative to international currencies and therefore your portfolio would lose value, or your foreign debts become more difficult to pay for in local money, and the second risk is that the Australian Dollar will rise compared to other nations and therefore your foreign investments will devalue in local terms.

This is a complicated risk to manage, because there are many variables to consider. For example, a number of people once hit upon the idea of borrowing money in Japanese Yen once when interest rates over there were only a few percent. They did not count on the Yen rising substantially against the Australian Dollar and hence their debts ballooning out and in some cases bankrupting the borrowers. There is a very good reason why the world’s banks don’t all just borrow money from the countries with the cheapest interest rates and then lending it out locally at the going rate, and that is precisely because of the risk of adverse currency movements. A number of farmers got themselves into big trouble with Japanese loans a while back, and this all ended in the courts with these borrowers suing their bank advisers for failure to disclose this risk.

If you have money invested in foreign markets, you would benefit from foreign currencies moving up against our own, but you could just as easily lose money if the Australian Dollar rose against these currencies. In the long term it is generally agreed that currency risk doesn’t hurt a globally diversified portfolio to any significant degree, indeed it can be said to add a valuable amount of diversification to a portfolio, but in the short term it can add a significant amount of uncertainty to returns. Many managed funds put risk management controls in place that reduce their exposure to foreign currencies, taking on only market risk for that asset class.

A slightly different view on currency risk is that if you have 100% of your money invested in Australian currency you aren’t well diversified. This may not seem a likely occurance locally, but just look at Argentina and other similar countries to see what an impact severe inflation can have on your spending power. Having money invested overseas in foreign currencies can insulate you partially against this sort of crisis. If you fear that there is some risk of the Australian economy ever suffering from some inflationary catastrophe then money invested in a diversified foreign currency based managed fund can be a very useful asset. This is one of the reasons why I say that currency fluctuations can help diversify a portfolio.

Legislative risk

Legislative risk is the risk that the law will change and ruin a perfectly good financial strategy. An example would be changes to the way investments are taxed, superannuation contribution or preservation rules, concessions and rebates, estate planning laws and other similar matters.

It is probably the hardest risk to deal with because it involves politics. Staying in touch with a lawyer can be a good idea, but is usually expensive. Financial planners deal with this by keeping up to date on legislative issues, continuously attending professional development seminars and subscribing to various technical magazines. Personal investors can deal with the risk either by doing the same, by using an adviser, or simply not relying too heavily on any one strategy, which is always a good idea anyway.

Compliance risk

Compliance risk is the risk that something you are doing is illegal, whether you realise it or not. Ignorance of the law is not a defence, and the law relating to tax and superannuation is about as complex as legislation can be.

In particular, Self Managed Super Fund trustees need to be very careful because there are major restrictions on what is an allowable investment policy and what is not, there are both civil and criminal consequences for non compliance and a trustee is personally responsible for ensuring these do not occur. Worst of all, you cannot hide behind an adviser for this because the law only recognises a SMSF trustee as responsible for what the fund does, not the trustee’s advisers.

The best remedy to compliance risk is to stay to the straight and narrow, don’t try to be too “clever” with aggressive tax strategies or contrived structures. Sometimes people with apparently impressive qualifications promote aggressive schemes, but the Australian Tax Office does not shy away from going after people that claim to be experts, indeed sometimes it may deliberately target high profile advisers to score a more impressive “scalp” as fair warning to others.

One thing to remember is that Part IVa of the tax act, which applies to tax avoidance, is very broad and gives investigators enormous flexibility to declare schemes to be “contrived” for tax purposes. There are many that believe that there are extensive loopholes in the tax system and that people have every right to exploit them. The Australian Tax Office has the power to audit individuals and look back many years into the past, if they feel suspicious.

I refer my SMSF clients to a Perth based superannuation specialist tax lawyer. This lawyer operates a compliance service that will automatically update your trust deed every year in order to ensure that the trust is always kept up to date and that strategies employed are acceptable, as at June 2002 this service costs only $100 a year, so it is good value. A good accountant and/or auditor is also recommended.

Management risk

Management risk is the risk that the managers of a fund you have invested with will make mistakes and lose money on investments. This risk varies widely from fund to fund, it is a practically insignificant risk with passive indexed strategies like I use, however for some active funds the risk can be substantial. The reason why you pay an active manager is because you hope that manager will generate higher returns and/or lower risk with careful selection and timing decisions on assets. Active managers may add value through their investment processes, but just as often they destroy it with their mistakes.

Fraud

None of the risks mentioned above involved deliberate deception (except sometimes credit risk). When deception is deliberate you are obviously far more likely to take a loss than when an investment is offered with nobler intentions.

In Travis’ investment FAQ there is a whole section on fraud, and ASIC have a good site http://www.fido.asic.gov.au which explains fraud in greater detail. The following rules dramatically reduce the likelihood of being scammed:

  • Never buy an investment without a valid prospectus or Product Disclosure Statement.
  • Only deal with advisers that provide a Financial Services Guide, have an Australian Financial Services License, have completed formal accreditation courses such as the Diploma of Financial Planning or equivalent, are members of an independent external complaints resolution scheme such as the Financial Industry Complaints Service and have adequate professional indemnity insurance.
  • Only act on written financial advice, do not accept verbal promises and assurances.
  • Be suspicious of individuals that mix “motivational” material and platitudes about being super rich with investment advice, promise to tell you about “secret” strategies that only the wealthy know about or promote themselves with over the top rags to riches testimonials and dubious autobiographies.
  • Never deal with organisations that are based entirely overseas, in particular those that promise to help set up secret offshore trading accounts or tax dodge vehicles – these are illegal and your chances of getting your money back are even less than when you deal with the local shonks.
  • Avoid dealing with advisers that randomly cold call people – only deal with a financial adviser that you have approached, or who has been introduced as a referral by a trusted friend or relative. Even if someone you trust refers you to an adviser, bear in mind that perhaps your trusted friend was scammed first, so you still need to do your own due diligence.
  • Don’t buy into any of the following: expensive wealth building/real estate/trading seminars (the money is made in selling seminars, not going to them), multi level marketing (always a scam), black box trading software (if it worked as they claimed, they wouldn’t need to sell it), any investment you don’t understand (a can of worms), any investment promising returns more than a couple of percent higher than off the shelf managed funds (if it seems too good to be true, it is probably a lie), anything being marketed as a “sure thing” (no such thing, unless it is a cash management trust paying low rates), any investment that you need to keep secret with confidentiality agreements (good advisers would be happy for you to tell your friends about them, scammers hope they can keep things quiet long enough to take your money and then vanish), anything illegal or doubtful (now that is just asking for trouble!), anything where you have to send money for information (advance fee fraud) and any investment being sold or recommended by unlicensed individuals, even if they are your friends or members of your community, ethnic, religious or social group(affinity fraud).
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