Investors should be conscious of three types of risk

As we approach the festive season and look forward to spending time in the company of family and friends, the events caused by the eruption of Whakaari-White Island seem all the more tragic.

For those caught up in this event, what should have been an interesting and exciting end to 2019 has ended in suffering and grief.

To me it is a salient reminder that in life we run risks all the time. Sometimes we take these risks knowingly and at other times we do this through ignorance.

The reality is when we don’t experience a negative consequence personally, we can easily become complacent; we end up discounting the true risk that we are taking.

I was recently talking with a client who works as a chemical engineer in petroleum exploration. He explained in that industry there are some potential outcomes so horrendous merely reducing their probability is not enough. The goal has to be the practical elimination of those risks.

As an adviser, I encourage my clients to think about the risks they face when investing under three headings: volatility risk, liquidity risk and the risk of permanent capital loss.

Volatility risk relates to the variability of returns. This risk is the one most clients intuitively understand; you can accept a low return with low volatility, or you can seek a higher but more variable return. Your ability to profit from this risk is generally governed by your investment timeframe (i.e. how long you can wait to achieve the desired return) and your investment temperament (i.e. are you emotionally capable of continuing to hold an investment during a negative period?).

The risk questionnaires advisers often have their clients complete before making investment recommendations seek to understand the clients’ response to volatility.

Once this parameter is understood, an adviser can create a portfolio blended from cash, fixed interest, property and share investments.

There are good statistics to help guide both the client and the adviser in the discussion about the trade-off between the average rate of return they may receive and the risk they are taking.

However, it is important to understand investors can transform volatility risk into permanent capital loss if they lose their nerve and exit at the bottom of a market cycle.

The second risk is liquidity risk. This is the risk that you might not be able to access your investment when you need to, or you may need to sell at a discount to access it.

Direct property investment is an example in which liquidity risk can exist. The difficulty is that quantifying this risk in advance is problematic.

Whether you can find a buyer at the price you want at some future point in time is generally unknown. If you are going to accept liquidity risk, then what additional return should you be paid as compensation? In my view, many investors tend to discount this risk.

The third risk relates to the possibility of permanent capital loss. For most clients, this risk is not too dissimilar to the extreme risk described by my chemical engineer. The impact of permanent capital loss can be catastrophic. Holding several separate investments can help manage this risk. However, the experience of investors in finance companies during the Global Financial Crisis showed it is possible for an entire sector to come under pressure and experience permanent capital loss. Fraud is another potential source of this risk.

The reality is humans have short memories. When investment markets have performed well for an extended period (as has generally been the case of late) we often underestimate the risk we are taking.

Investment risk can never be completely eliminated and, in fact, it is the acceptance of risk that helps drive return. However, as mentioned in introduction, it is the risks we are taking through ignorance that tend to blindside us. The role of an experienced adviser can help you identify and manage the range of investment risks you face.

Wishing you and your family a risk-reduced festive season.

Peter Ashworth is a principal of New Zealand Funds Management Limited, and is an authorised financial adviser in Dunedin.


 

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