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.
Understanding risk can help many investors to identify new investment 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 often become 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 principal/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.
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 increase investors exposure 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 rates rise and fall over time.
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.
Depending on the type of market the investment is trading or held within, liquidity risk can become a factor to consider.
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.
However, 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.
Managing risk through diversification
Diversification should be the default mode for most investors. Investing in this way 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 more risky to keep all of your eggs within the one basket, and you may suffer the consequences through lower 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.
Learn more about investing in Trilogy's range of mortgage trusts, diversified income funds and property trusts.
This article has been prepared by Trilogy Funds Management Limited (Trilogy) ABN 59 080 383 679 AFSL 261425. This advice is general advice only and does not consider your objectives, financial situation or needs. You should consider whether the advice is suitable for you and your personal circumstances and we recommend that you seek personal financial product advice on your objectives, financial situation or needs and obtain and read the relevant product disclosure statement before making any investment decision.