Understanding risk

Last updated on 12th December, 2017 at 05:13 pm

When you decide to invest your money to achieve your financial goals, you deliberately decide to take on risk. The fact is, investing in any financial instrument or asset class poses inherent risk.

Getting a handle on risk can go a long way in lowering the stress levels and empowering you to plan – and adequately provide – for the future. It is therefore paramount that you get to grips with the concept and implications of risk. For example, how much risk, financially and psychologically, should you tolerate? What risks do the different asset classes and financial instruments present? What are the variables at play, and how best can these be managed? While the mere mention of the word ‘risk’ invariably evokes a negative connotation associated with the threat or possibility of loss, your financial adviser will tell you that you actually need to take on a certain amount of risk to realise your financial goals. By running you through a risk profiler, your adviser will likely determine your propensity for risk and tailor your investment choices and strategy accordingly. This knowledge will assist you to better understand the opportunities, trade-offs and costs involved in different investment approaches and products.

Fluctuations in interest and inflation rates

As you make your investment decisions, your financial adviser will cite the risks posed by each asset class and financial instrument, as well as the extent to which fluctuations in interest and inflation rates influence the risks associated with certain investments. As financial markets generally tend to be volatile, there is always the risk that in certain circumstances a particular market, say the share market, will decline sharply. It is therefore important that you do not put all your eggs in one basket. In other words, it’s wise to diversify your portfolio by spreading your investments across several asset classes and sectors, aiming to minimise your overall risk. At the same time, when markets lose value in volatile times, it’s advisable not to churn or sell your investments in a blind panic. Instead, in the long run you may actually gain by sticking to your investment strategy and riding out the proverbial wave.

Asset classes and risk

In terms of asset classes, your financial adviser will tell you that cash is considered the least risky, but that it’s tax inefficient and delivers correspondingly low returns. This means that in a relatively high inflation environment, like now, the value of your cash can be eroded over time, which in itself is a form of risk. At the other end of the scale, there could be shares that are considered highly risky because of, say, corporate unpredictability and market volatility brought about by various macro-economic, social and political factors. In between on the risk scale are fixed income and bonds where you lend money over a fixed term to government or companies in exchange for regular interest. A notch further up the risk scale are investments in residential or commercial property.

Risk and return

Whichever asset class you decide to invest in, remember that in the financial world, risk and return go hand in hand. So the investment risk will be higher if you want the best possible return. Conversely, if you focus too much on avoiding capital risk, your money will not work for you as well as it could and the return most likely will be lower or possibly even negative. Therefore, before making any investment decisions, you should carefully and pragmatically consider all the risk factors of each of the various asset classes, along with your individual risk profile and investment horizon. In the final analysis, the risk you take when you invest your hard-earned cash is solely yours, so it’s best to be extremely cautious. And don’t be impatient, it can cost you.

By Wilma de Bruin

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