13 investing and risk terms you need to understand
1. Risk profile or risk tolerance
Your risk profile, which financial advisers often talk about, or your risk tolerance is your ability to withstand losses in your portfolio. Some people compare it to your ability to sleep at night - if your portfolio were to fall 5%, could you sleep at night? What about 10%? 20%? From there you can start to understand what your risk tolerance is. This determines how you should invest with that. Your risk tolerance will change during your lifetime and your stage of life. If you have a long time to make up any losses or have fewer current financial obligations, you might be more open to taking a greater risk. Typically as you get older and have less time to make up any losses incurred, your risk tolerance decreases. When calculating your risk tolerance, it's also important to see your total wealth and understand exactly what you are risking with particular investments.
2. Risk vs reward or relative risk and potentials return
The potential of reward from an investment is related to the amount of risk you are willing to take. For example, if you are keeping your money in the bank it's considered safe as there is a government guarantee. Subsequently, the reward you receive is low. If you are investing in a company through shares, the risk is greater as there is potential for the company to do well or not do well. A blue-chip stock, which is invested in a large company with a long track record, is seen as safer than a smaller, newer company so the potential reward is lower for the blue-chip than the newer company. Speculative investments, where you are taking a larger risk that the investment will pay off, will need to reward you well to encourage you to take the risk, and this is how risk and reward are related.
Diversification is making sure you don't put all your eggs in one basket. In investment terms, it can refer to industry, geography or the type of assets. Your investments should be diversified to protect as much of your total asset pool as possible if one segment of the market hits a downturn. For example, your investment portfolio may be broadly made up of cash, fixed interest, property, and equities. This is asset diversification. To diversify further - property might be further diversified to include commercial, industrial, residential and more, and it may be further diversified by location - both national and international. Equities and other investments can be similarly diversified.
4. Volatility index
VIX is the accepted marker for volatility. Better known as the volatility index, it is an indicator of whether there is excess fear or optimism in the market. It tracks the volatile of the S&P500. When sentiment reaches one extreme or the other, the market will typically reverse course. When VIX is low then volatility is low and when VIX is high, volatility is high - and this is typically stirred by market negativity.
5. Sequencing risk
Sequencing risk is the effect that the timing of volatility has on your investments. If you don't need to access the investment for some time there will be time for it to recover, however, if you are in retirement or nearing retirement, a marked fall in your assets may have a larger effect. There is also a risk in retirement, particularly in pension phase, that if you need to withdraw your funds at a time when certain assets have performed badly the losses will be compounded over time. This is why as people reach retirement they may invest a smaller amount in high growth investments.
6. Inflation risk
Inflation risk refers to the effect that inflation can have against your investments. If inflation is rising at a greater rate than your investments you will effectively be losing money. This is because inflation is reflected in the prices of goods and services and if your ability to purchase these isn't growing at the same or a greater rate, your ability to purchase them in the future will be lowered, and you will be only able to purchase less.
7. Interest rate risk
This refers to the ability of interest rates to affect your investments. For example, if you are holding bonds and the interest rate rises, the value of your bonds will fall because there will be less demand for them if interest rates rise to a higher level elsewhere. However, if rates fall, more people are likely to invest in equities and their price will rise.
8. Concentration risk
Concentration risk refers to the potential for a single investment or class of investments to threaten an overall portfolio. It typically refers to the concentration of region, event, commodity, investment, political outcome or credit. If just one of these areas is impacted, a concentrated exposure would have the potential to affect the whole portfolio.
9. Market risk
Market risk is concentrated on the performance of financial markets. Typically all investments may be affected by a market downturn such as the current pandemic. Hedging a portfolio can sometimes help mitigate falls due to market risk, by buying out options to protect against a downside move.
10. Liquidity risk
Liquidity risk is something that is being faced currently by many super funds as people are taking advantage of being able to access their super to help through the COVID-19 financial downturn. It is the risk that you won't have the ability to convert investments to cash to meet short-term money demands. This may be because investments are in large, difficult to sell items - such as large property developments - or the investments you hold are difficult to find buyers for. Liquidity risk will usually see a large loss of capital if the need arises to sell in a buyers' market. To avoid liquidity risk an investor should make sure that short to medium term needs can be met without having to resort to the potentially illiquid sections of their portfolio.
11. Currency risk
This is the risk that exchange rates go up or possibly down affecting investments that you have made in different currencies. For example, if you invest in the US with Australian dollars and the US dollar appreciates, your US investment will also appreciate in AUD terms. However, if you invest in the US with Australian dollars and the US dollar depreciates against the AUD, your investment will be worth less in AUD. You can hedge against currency risk with many investments - however, currency risk may be part of your investment strategy.
Alpha is the key measurement of the amount an investment has returned in comparison to the market index or benchmark that it is compared against. The outperformance amount is referred to as the investment's alpha.
Beta is the amount of volatility of an investment in comparison to the market or benchmark. The base number for beta is 1 which means it moves in line with the market. If it is <1 it means it is less volatile than the rest of the market, if it is >1 it means it is more volatile than the market. For example, if it is 1.2 it is 20% more volatile than the rest of the market. 14. Sharpe ratio Developed by Nobel prize winner William F Sharpe, this ratio is used to help investors understand the return of an investment compared to its risk. The ratio is based on the average return earned in excess of the risk-free rate per unit of volatility or total risk. If the ratio is greater than 1 it is considered to be good, if it's higher than 2 it's rated as very good and at 3 or over it's considered excellent. If it falls under 1 it is seen as sub-optimal. The risk-free rate is typically determined by the shortest-dated government bonds.