Understanding Risk
A few common investment risks and their solutions:
Inflation
The impact: Rising prices destroy the spending power of your savings.
The best solution: Real assets that have earnings that grow as inflation grows such as shares and property.
Deflation
The impact: Falling prices mean interest rates fall to almost zero (as in Japan) and company earnings fall, as do many share prices.
The best solution: Money. Avoid real assets as prices fall. Shares that pay interest are the best protection as they generate cash, which increases in value under deflation.
Market volatility
The impact: Share prices are the most volatile and can fall 20% in a day. Property prices are also volatile but less visible.
The best solution: Cash and fixed interest. This can act as a buffer to volatility in share and property markets. Having the correct asset allocation for your risk profile is the key.
Fraud
The impact: Errant company bosses, investment advisers, or anyone involved in the investment process commits fraud, resulting in losses to shareholders or lenders.
The best solution: Being comfortable with the management of the shares or other securities is a first step. Diversification is the other, and more thorough, protection.
Credit risk
The impact: The risk that an issuer of deposits, bond or other fixed interest securities falls into financial difficulty and is unable to repay your capital.
The best solution: Focus on high grade issuers, even if it means lower returns, and have a range of securities from a range of issuers.
Currency movements
The impact: Currencies are horrendously volatile. The strong New Zealand dollar of the past few years has decimated returns for investors but avoiding foreign currencies can be even worse for your financial health.
The best solution: Diversification into global currencies is important, especially for New Zealand investors who live in a small country with a fragile economy. Short-term volatility can be limited by holding a range of currencies.
Taxation
The impact: Investors note: tax matters. It can drop your return from fixed interest to below inflation (see the 1980’s) and it can eat into your capital gains.
The best solution: Invest in a tax efficient manner. Prefer direct holdings where possible.
Hidden costs
The impact: Hidden costs are rampant in the investment industry. Over 30 years, we estimate 2% extra fees per annum on an investment of $500,000 earning 10% will mean the end value will be $5.0m instead of $8.7m.
The best solution: Invest directly when possible to avoid layers of management fees.
Liquidity
The impact: Some investments are more liquid (easy to buy and sell) than others. Try selling a house in a property downturn – it can take months, if not years.
The best solution: Shares have the highest degree of volatility, followed by bonds. Listed property trusts are a good way of getting around the inherent illiquidity of direct property.
Interest rate risk
The impact: Interest rates are constantly on the move. A significant change, either up or down, can catch you out if your portfolio is positioned incorrectly. If you have too much cash, falling interest rates will reduce the value of your overall return, while rising rates will reduce the value of your longer term bonds, not to mention your shares and property investments.
The best solution: A laddered portfolio of fixed interest securities across varying maturities is the best protection against interest rate movements. In the past, growth shares have handled periods of rising interest rates better than other shares.
Bubbles
The impact: Investors are famous for their over-exuberance. Whether it be in the shares of investment companies, tech shares, or today’s bubbles in debentures, houses and hedge funds, people often get carried away. The result is always chaos as the inevitable happens and the bubble bursts.
The best solution: Have in place an asset allocation strategy and stick to it. Keep disciplined and diversified and reduce exposure to markets and sectors that look over exuberant.