The Game Of Risk: Investing Edition
This article is sponsored by Securities Commission Malaysia, under its InvestSmart initiative.
“The higher the risk, the higher the returns” is an investment rhetoric that has been reiterated almost as often as the question of “How much are you willing to lose?”
All investments come with risk and dealing with risk is a normal part of investing. It is impossible to avoid all risks when investing, but being mindful of the various risks present and keeping within a level of risk that you are comfortable with will go a long way in protecting your investment portfolio.
Different investments come with different risks. In evaluating an investment, you should consider the various risks that may affect its performance to determine whether it is a worthwhile investment.
What are the types of investment risks?
1) Market risk
Market risk is the risk of losses arising from movements in market prices. If you invest in stocks, you will have to accept that economic uncertainties in Malaysia and the world over will cause your investment values to fluctuate.
For example, in February 2007, after rumours that the Chinese government was going to raise interest rates in an attempt to curb inflation, the Chinese stock market tumbled 9% in a single day. The effects of the plunge quickly ramified through the global markets as the world reacted to the largest meltdown in 10 years.
2) Default risk
If you have invested in a company’s bond, you would generally expect a return. The promised returns would usually be higher than what a savings account would offer, but there is always a risk of the company defaulting.
A company or an individual is considered to have defaulted when they are unable to make timely principal and interest payments. A default risk is higher when investing in a single company through stocks or bonds, especially when the underlying company’s fundamentals are weak.
3) Inflation risk
Inflation risk is the possibility of future asset or income depreciation due to changes in purchasing power from inflation. This is a constant risk in every country and occurs regardless of whether or not investments are involved.
Inflation undermines the performance of your investment. Many financial planners usually estimate inflation to be at about 3%–4% per annum in their calculations on expected “real” returns for an investment.
For example, a relatively modest 3% rate of inflation will reduce the purchasing power of an individual earning RM3,000 monthly to RM1,660 in 20 years.
Given its profound impact, inflation needs to be factored into any long-term investment portfolio. Some rational responses to inflation risk include buying investments with higher returns such as stocks and property.
How to manage risk
An investor’s ability to weather large fluctuations in the value of their investments depends on his or her risk tolerance levels. If you have the safety net of a large capital reserve, a steady and high income, the advantage of youth and holding power, you will be in a better position to invest in riskier portfolios.
If you’re 25 and are saving for your first home and wedding, you can afford to roll the dice a little bit more and put some of your money in higher-risk investments such as stocks. Being young gives you a longer time horizon, which in turn allows you to weather and ride out the market’s highs and lows.
However, if you are 55, nearing retirement and hoping to expand your retirement funds, you might want to play it safe and opt to invest in lower-risk instruments such as unit trusts or bonds, while decreasing your investments in high-risk instruments such as stocks.
Each investment vehicle has its own characteristics and comes with its own set of risks, and almost all are subject to volatile market conditions. An effective method of managing investment risks is to build a diversified portfolio that holds several types of investments.
The idea of diversification is that if one investment incurs losses, profits from other investments will be able to cushion the impact of the losses.
While there is no guarantee that you will not suffer losses if the market performance drops, you can mitigate the possibility of incurring losses through diversification.
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