Types of Risk

The basic definition of risk is that your financial expectations will not be achieved. There are various events that may result in your expectations not being achieved and they include:

Investment Risk

One way of illustrating investment risk is to compare a term deposit in, say the Commonwealth Bank with buying shares in a company, say Coles Myer Limited.

The term deposit with the Commonwealth Bank is a low risk investment and has a high likelihood of giving you the positive return you expect. Before you invest you know how much income you will receive during the investment period and how much capital you’ll receive back at the end of the investment period.

In comparison, buying shares in Coles Myer Limited can be of moderate to high risk in the short term. Even though information is available which can provide you with an indication of the amount of dividend income you may receive based on Coles Myer’s history of paying dividends, each dividend payment depends on Coles Myer’s profitability at the time. Similarly, projections may be made about the price of Coles Myer shares in the future based on future profitability, but its share price will vary daily. This means that you can never be sure of your investment return from shares.

Therefore investment risk is the probability that your investment portfolio will provide a lower rate of return after tax than could have been achieved using risk free fixed rate investments over the same period of time.  

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Volatility Defined

Volatility means how much an investment will rise or fall within a particular time frame. Cash usually has no capital volatility - the value of your initial capital never changes, although the income return will vary according to movements in interest rates.  On the other hand, shares have a high level of volatility because share prices can change from minute to minute - experiencing many rises and falls over time. In addition, the dividend income you receive from your shares will vary according to the profitability of the companies that you invest in.

Therefore the critical factor when applying volatility to an investment portfolio is for the value of your investments, as well as the income you receive, to rise over the medium to longer term. Short term capital volatility should be regarded as acceptable, however short term volatility of income is to be avoided.

Volatility is not the same as risk, but it is an important component of the risk equation. This means that you need to ask yourself what time frame you have until you need your capital and how much volatility of capital value you can bear in the interim time period.  

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The Importance of Investment Time Frames

Risk is dependent on your time frame and risk generally decreases over time. So a long term investment (10 years or more) could have a high likelihood of giving you the investment return you expect after 10 years, even though in any one year the return may be unpredictable. Thus our Coles Myer investment will probably have a low risk of capital loss over 10 years even though it may have a higher risk over any one year.

When you are considering your tolerance for risk, you need to ask yourself the following questions:

The answers to these types of questions give an indication of your attitude to short term risk. They help us to determine firstly, your risk profile and secondly, a suitable asset allocation for you.  

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Market Risk

This is the risk that you may incur a capital loss due to a significant fall in property or sharemarket values. You may also incur a capital loss in the event of an increase in interest rates.

Legislative Risk

Changes in government policies, particularly in respect to superannuation, taxation and Social Security legislation can result in an investment strategy no longer being effective.  

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The Relationship Between Risk and Return

There is a very close relationship between the level of risk associated with a particular investment and the amount of investment return that is likely to be achieved. This means that the higher the risk you are prepared to take, the higher the return you are likely to get.

With the fixed term deposit at the Commonwealth Bank you know exactly what you will get in terms of interest and that you will get all of your capital back at the end of the term. Coles Myer on the other hand has a higher level of risk in the short term, but as it continues to grow and become more profitable over time, its share price will go up and you will get a share of that increasing profit. Thus, its total return will consist of the dividend income plus any increase in the share price over time.

This is the reason that bank deposits produce low returns, whilst quality sharemarket investments produce significantly higher returns over time.  

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The Role of Diversification

Diversification is one of the most important investment methods of managing investment risk and enhancing your investment returns. In a nutshell, diversification means that you must not put all of your investment eggs in the one basket. It is critical that your investments are spread over the main investment areas of property, shares, interest and cash. Diversification can be extended even further, by including international investments within your portfolio.

Furthermore, it is important that you also spread your investments over a number of different financial institutions and / or companies operating in different sectors of the economy. When diversifying over different financial institutions or fund managers, it is important to use managers that have complementary investment strategies. Otherwise you may have a number of different investments that all operate in the same way and will respond identically to market fluctuations.

As an example, if you only have shares in one company, your income and capital returns are totally dependent upon the profitability of that company. If dividends are lower than expected, or if you have to sell at a time of market weakness, you may suffer significant financial loss.

In contrast, if you had diversified your portfolio by investing in a range of say ten different investments and one of those investments produced a lower than expected return, or even failed, your overall losses would be limited, as you would still have another nine investments that were providing you with satisfactory investment returns.

When selling an investment in a diversified portfolio, a particular loss in one area may have been offset by gains made in another, so the overall return may not have been as badly affected.

Diversification across all asset sectors of property, shares, interest and cash is most appropriate for an investor who wants a balanced portfolio giving good returns and moderate risk. Such extensive diversification may not be appropriate if you are a highly conservative investor who wants very low risk, or if you are an aggressive investor who wants higher returns.

Contact us:  enquiries@directadvisers.com.au

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