Brent Sheather: Unveiling the faces of financial risk

Risk comes in 10 varieties for investors, says Australian publication Understanding Risk to Achieve Your Financial Goals. Four of those risks were outlined the week before last. This week, we look at the remaining dangers.

Market risk

This refers to volatility, or the extent to which the market value of your investment will fluctuate, moving down as well as up.

Different types of investments experience different levels of volatility. Investments expected to produce higher long-term returns generally experience more volatility.

This volatility becomes a problem if you don't have the time to ride out the rough patches.

It's important to remember that markets go through regular ups and downs.

Although it's tempting to sell an investment after its value has fallen, historically investors who stick with their strategy generally go on to recover and prosper.

Timing risk

Many people believe investing is about timing the market, getting in before prices rise, enjoying the ride up and then getting out before prices fall.

Yet anticipating these market moves can be extremely difficult because no two market cycles are the same. Investors' emotions make successful market timing even harder.

Although logic suggests the best time to buy is when asset prices are cheap or falling, many investors tend to buy when prices are rising and sell when they are falling. The emotions of fear and greed can lead us to buy and sell at exactly the wrong times.

Despite how much is written about market timing risk, it is surprising how many financial advisory firms rely on switching clients from cash to property to shares to bonds as part of their monitoring service.

Some even use an investment clock that is supposed to identify which asset class will do best in each economic condition.

In practice, no system works and certainly nothing this simplistic. All traders will probably do is generate fees and brokerage for their adviser and a tax liability for themselves.

Far better to buy and hold, although that isn't guaranteed to give you positive returns even after 10 years if you buy at the top of the market.

Currency risk

Investing internationally has its own risks. By buying overseas assets, you are taking a risk on the relative value of the kiwi dollar against other currencies.

Currency moves can wipe out any return you generate from the overseas assets. Alternatively, they can generate a currency-related profit.

Gearing risk

Understanding Risk includes a note on the risks of gearing or investing with borrowed money.

The local sharemarket offers investors another way of gearing, via options or endowment warrants.

Either way, individuals are making a judgment that they can earn more on their funds than the cost of their borrowings. It isn't always so, and gearing can greatly magnify the impact of mistakes and cloud your judgment when the market falls.

Eggs and baskets

Diversification means spreading your money across different investments to reduce the risk - the opposite of putting all your eggs in one basket. This is a common-sense rule and usually gets rehearsed in the newspapers at least once a week.

Despite this, a lack of diversity is usually at least part of the reason for investment disasters.

So why don't we diversify? There are several reasons: greed, fashion, fees, adviser bias and new issues. Most mums and dads with money to invest should buy managed funds which give the required diversity - the key is to buy the ones with low fees.

Liquidity risk

Understanding Risk describes this as the risk that, if our circumstances change and we need to sell investments, we incur a loss.

The conclusion is, therefore, that we should keep some cash aside for emergencies. Not a lot of rocket science there - but there is more to liquidity risk: the textbooks stress that liquidity is an important component of price discovery.

Assets can be mispriced due to a lack of liquidity - another way of saying there are not many buyers and sellers in the market of the asset.

Property is an asset which readily lends itself to contrived and manipulated prices because the methodology for pricing property is not well defined and the market in real property is not liquid.

Where the market in an asset is thin, with not much trading taking place, there is typically a big spread between what buyers wish to pay and the price that sellers require.

Small companies or thinly traded stock exchange-listed options come to mind; if you wish to sell quickly you must meet the market and the impact of even a small buy or sell order can be substantial.

The lesson for the non-expert mum and dad is perhaps that they should stick to the large, liquid companies, property funds and bonds favoured by the institutions.

But there is yet another way to look at risk - a definition which relies less on investment theory and more on day-to-day practicalities.

Maybe we should define risk in terms of the variability that each competing investment exhibits in terms of meeting our primary goal.

For most retired people, the priority is income, so perhaps an analysis of risk should look at the variability of the income component of return, not total return as is accepted practice.

This would make asset classes like international shares, which pay meagre cash dividends and instead rely on highly volatile capital gains to generate returns, look much more risky than higher-yielding sectors such as local shares, property and bonds.

Brent Sheather is a Whakatane-based investment adviser.