by Aunty Scott
In the financial world there is plenty of risk around, just turn on the news or read your local finance blog and there is plenty that you could worry about. Risk that you will loose money, risk that you will not achieve your investment returns, risk that the Government will change the rules and your investment strategy will no longer work, risk that Europe and the United States will not be able to sort out their debt issues.
So this month we are talking about what risk is and some ideas around how best to manage risk in achieving your goals for life and in management of your investment portfolios!
What is Risk?
Risk can be defined as the possibility of something bad happening, or things not turning out the way you would like them too.
Risk in the World of Investment
In the world of investment risk is the term used for the possibility of losing a portion of your money (this could also be called capital risk) or uncertainty of not achieving your income expectations (income risk).
To some people risk may represent an opportunity to accumulate wealth faster, or get into an asset when others are not keen to be buying it. This potential for higher investment return is why people invest and take on the risk for the potential of a better outcome.
I break investment risk into two areas:
- Capital Risk – The risk that the capital you need at your planned time in the future is not there or available.
- Income Risk – The risk that the income return you need to achieve a goal or an outcome is not there or available when your reach the timeframe.
Even cash in the bank, although it is considered the least risky asset has income risk. For those who had cash in a bank account in 2007 will remember the 9% interest rates you could get from your high interest cash account. Today the best rate I have seen is around 6.51% for a high interest cash account.
Property and share based investment be it Australian or International investments have an income return (depending on rental or dividend payment) and they also have a potential for capital growth return. Understanding what the investment you are going into is going to provide will help you to plan.
Risk in relation to your Plans in Life
When it comes to mapping out your plans and goals for life I like to ask clients about any obstacle that they think could get in their way to achieve there outcomes. Because risk ultimately is the unknown so if we can get more educated or empowered about things it can assist in reducing the risk.
In some cases such as disability, accident or premature death you can take out insurance to manage some of the risk in relation to your plans in life. But there could also be other obstacles that have no financial impact but could provide just as much stress or worry.
An example here is a client I was working with who had different outcomes planned in life to her father. We had to work out an appropriate strategy to get him on side and excited about her plans for her life so that she could start to achieve the things that inspired her.
Can You Manage Investment Risk?
Yes most definitely!
1 – Educate Yourself – Understanding the What, When and Why of your plans, the investment products you are using and your strategy is the first stage to mitigate and manage risk in your portfolio.
2 – Follow a Goals Based Investment Approach – If you know what your outcomes are and when you need to access your fund this can really improve your overall position. Keep enough cash in an emergency fund (get a high interest cash account or use a mortgage-offset account if you have a mortgage) and set aside at least $2,000 for any emergencies.
3 – Income or Capital Growth – Map out if you want income or capital growth returns (or a mix of both) and be sure that you understand the investment that you are buying into and the minimum timeframe that you ideally need to invest for. Unfortunately there are no get rich quick schemes and if anyone is talking about them I would be walking in the opposite direction!
4 – Diversification – The old “don’t put all the eggs in one basket” analogy. Each investment as it behaves differently will do things at different times in a market or business cycle. Each have their ups and downs and by owning a mix of different assets focused on achieving your plan will help to smooth out some of this risk.
Depending on how you are investing will depend on how you diversify. If you are investing into managed funds you can invest across different managers and asset classes, if you are investing directly into property and shares you can diversify across different companies or industries or suburbs.
For example a property will perform differently to the share market which both perform differently to gold or other precious metals, which also perform differently to cash and fixed interest investment. A good adviser can help to map out the right strategy for you.
5 – Stay on Track and Review your plans – Once you have mapped out what you are trying to achieve and your timeframes and have researched (or outsourced the advice process to a financial professional) you should continually review how your investment are performing and that the strategy is doing the right things for you.
Where do assets sit on the risk spectrum?
The chart above shows a very general guide as to where different types of investment sit. Cash being the least risky, with shares being the most risky, the point to note here is that the higher the perceived risk the trade off should be a greater opportunity for a higher return.
Where to from here?
Risk management is just one element of your overall plans in life and your investment portfolio. If you need assistance in exploring any of this further talk to a professional adviser but most importantly start your journey to being free around your money and creating wealth with understanding.
Scott Malcolm (scott@money-mechanics.com.au) is Director of Money Mechanics (ph: 1300 772 643) a fee for service advice firm who are authorised to provide financial advice through PATRON Financial Advice AFSL 307379.
The information provided on this article is of a general nature only. It has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information you should consider its appropriateness having regard to your own objectives, financial situation and needs.
