How To Live With Risk In Your Investment
Investment entails saving money with a long-term view in mind. It mainly involves dealings on the stock market. Broadly speaking, investors are exposed to two kinds of risk: 'specific' and 'unpredictability' risks. 'Unpredictability' risk can be further divided into 'market' risk, 'currency' risk and 'manager' risk.
Specific risk is the probability that the company whose security money has been invested in will not perform well. For instance, if £12,000 is invested in the shares of a company, and the share price drops by 50%, the investor will lose £6,000 of his investment. Specific risk can be the result of fraud or poor management in a company. Specific risk can be reduced by investing in a variety of companies. Another way of looking at it is making an effort not to put all of one's effort in the 'not putting all of one's eggs in the same basket. Thus if the same £12,000 mentioned above was instead invested in 6 different shares, placing £2,000 in each, a lot of the funds will be salvaged, if one company goes bust.
It must be noted that small companies have a higher tendency to bust, and compensate for this by normally paying higher returns. It is advisable to buy securities only from legitimate and authorised firms.
Market risk is the probability that the market index as a whole will fall. When this happens the market normally drags the shares of the constituent companies with it. It is difficult for a company to totally buck movements in the market index.
Market risk can be reduced by investing in various stock markets around the globe as well as in different asset classes. This is because although trends in one stock market affect other international stock markets, the changes do not occur at the same time and will have different magnitudes. Movements in the prices of the different asset classes will also not take place at the same time, and will occur to varied extents. Buying units in a unit trust or shares in an investment trust are very efficient ways for the private investor to protect himself against market risk. This is because the pooled funds of these institutions are usually invested in a wide variety of assets, both domestically and internationally.
Currency risk is the risk that the value of an amount invested in a foreign country will fall when the income and principal are converted into the domestic currency. This will result from a fall in the domestic currency relative to the foreign currency. An investment in an international unit trust or investment trust will help to combat such a risk. A fall in the value of some of the currencies will be smoothened by rises in others.
Manager risk has to do with the probability that the fund chosen will not perform as well as anticipated. History has shown that only one out of ten actively managed funds have consistently managed to outperform the stock index. Choosing a good fund manager, in practice, is not as simple as it sounds. Views of experts are divided between the possibility of predicting future performances from past ones. Index or tracker funds have proven to provide higher returns in the long-term than actively managed funds, and will be useful tools in controlling manager risk.
One golden rule of investment is that an investor should expect to take more risk if higher returns are expected. Another is that the longer the time-horizon an investor is prepared to accept for an investment, the greater his risk tolerance level. Risk is the fuel of an investment vehicle; there will be no investment without it. If it is properly harnessed and contained it can provide great returns, otherwise investment can go really awry.
David Opoku
BA Hons. Accounting and Finance. (Currently specialising in Financial Advising/Stockbroking).
I have a BA Hons. degree in Accounting and Finance. I am currently specialising in Financial planning.