Understanding risk and diversification

Home Learning Hub Understanding risk and diversification

Investing and risk go hand in hand, but it shouldn’t cause sleepless nights.

When you invest, you buy an asset or put your money somewhere in the hope of increasing the value of the asset or getting an income from it – or both.

Investment risk is the chance that the value of an investment will drop. Generally, the higher the chance of a loss occurring, the higher the investment risk, and the higher the expected returns should be.

All investments have risks. It could be the risk of losing all the money you have invested, or it could be the risk of investing conservatively and not having the return on your investment match inflation (which means your money loses its buying power and is worth less over time).

Understanding the risks associated with your investments and making decisions based on your tolerance to risk will allow you to sleep comfortably at night

A few ways to manage risk

Understand your financial goals and objectives

Understand the risks associated with various investments

Get to know how comfortable you are with various investments and asset classes

Risk vs return

The key principle is: potential return rises with an increase in risk. It becomes a balancing act to get the right level of return on your investments with a risk level you are comfortable with.

For example, investing in shares or directly in a business has the potential for high returns over the long term, but the value of your investment in the shares can fluctuate enormously over the short term.

Think about times when large amounts have been wiped off the share market in a single day.

Super is a good example of a long-term investment. Most super funds suffered drastically reduced returns after the global financial crisis (GFC) but are now getting returns at levels similar to those pre-GFC.

Yes, it can take time to recover, but by following one of the key principles of investing – time in the market, not market timing – generally you should get the results of a long-term trend.

The trick is to allow yourself long enough to achieve the trend.

Read more about understanding risk at MoneySmart Risk & return.

Types of risk

There are a few types of risk you should be aware of. Here are a few examples:

Volatility

Volatility generally refers to the value of your investment. Shares can vary wildly in their value while a cash investment retains its value. For example, a term deposit account cannot fall below the amount deposited.
Timing

When you choose to invest and when you want to ‘cash in’ your investment can make a huge difference to its performance.

The share and property markets can be going up or down at different times. Having a long-term view can reduce this risk.
Legislative

Taxation and super laws can change. There is always the risk that your investment returns will be different from what you’ve predicted based on these changes.

For example: a reduction in tax rates can make a negatively geared investment less attractive.

(Negative gearing is when the amount of borrowings against an investment do NOT match the returns. The hope is that the long-term appreciation of the asset will be worthwhile. In the meantime, a tax deduction is available for the loss each year.)

Currency

When investing in foreign currency or in overseas shares, the value of that country’s money against the Australian Dollar can make the investment worth more or less, depending on the value of one against the other.
Return

With an ever-changing economy, returns can vary greatly, even within a conservative investment.

Interest rates can drop from 10% to 5%; the returns from shares can reduce as companies make less profits; or rental income may be less than expected if more people buy than rent.

It’s the risk that investments don’t match goals or objectives.

Risks attached to different investments

Before you invest, you should be aware of the levels of risk associated with different types of investments. Here are a few examples:

Low

Cash investments - savings accounts/term deposits

Cash refers to money invested in bank accounts, building societies, credit unions, or cash management accounts. These investments have the least risk of all major asset classes but may not keep pace with inflation.
Low to moderate

Fixed interest accounts

Also in the ‘cash’ class but generally offering a higher interest rate are fixed term deposits or investments in the short-term money market.

Fixed interest investments include Government bonds, and debentures where you are lending money to a company.

These investment products can offer returns linked to inflation.
Moderate to high

Property/managed funds

Property is considered a growth asset and includes residential, commercial, and industrial property types, which you can purchase yourself or through a listed property trust. Purchasing yourself can mean liquidity issues if you need to offload the property quickly.

Managed funds are professionally managed investment portfolios that investors can buy into. Each managed fund has a specific investment objective which is based around different asset classes, making it easy for investors to choose a balanced fund that suits their goals and risk level.
High

Shares

Shares, stocks or equities are units of ownership in a company. If the company or share market performs well, the value of your shares may increase. On the other hand, if the company or the share market does not perform well, then your shares may decrease.

Shares are the most volatile in the short term, but can outperform other investment types over the long term.

Here’s an example of share market volatility:

Gerry Harvey (of Harvey Norman) bought 2.5 million Emeco Holdings shares at 80c in January 2008. If he had sold them in May when they climbed to $1.29 he would have made a healthy profit. But he didn’t, and in October they were trading at 69c. Gerry Harvey expects this type of volatility and recognises that, at the time, most of his portfolio was losing money on paper. He is confident that “share values will go back to where they were”.

There were no nasty surprises for Gerry because he expects volatility and isn’t relying on the invested money in the short term. His loss was only on paper because his portfolio is a long term investment and he wasn’t looking to cash it in.

Source: The Bull

Reducing risk through diversification

When looking at where to invest it’s important not to put all your eggs into one basket. It shouldn’t be a matter of choosing between shares or property, but rather balancing your portfolio of investments. This is called diversification.

No one type of security, asset class, investment strategy, or investment manager can provide the best performance all the time. So a range of investments should reduce the risk of investment experiencing drops in performance across the board, all at the same time; simply because one investment can perform well to offset the poor performance of another.

You can even diversify within a type of asset by investing in property in different regions, states, or countries, and you can buy shares in very different countries. For example, buying shares in mining companies as well as banks and internet companies across Australia and overseas is diversifying.

The mix of various assets within your investment portfolio is called asset allocation, and it is one of the most important considerations for any investment portfolio, within or outside of your super.

What type of investor are you?

Everyone aims for the highest returns on their investments…but how far will you go to make that happen?

Will you lose sleep if there’s a market downturn? How long do you have until retirement? How much time do you have to make investments work for you to match the goals you want to achieve?

There are three basic types of investors – conservative, balanced, and aggressive – and your investment strategy needs to match you goals and the type of investor you are.

Your choice of investment strategy should be made on the understanding of ‘how you feel about risk’.

Layla is in her mid-30s and investing for the long-term – greater than 5 years. She wants capital growth but realistically understands the volatility in returns and periods of capital loss that can occur over the life of an investment.

With some professional advice, Layla is setting up her portfolio with property and shares to provide her with high returns and an acceptable level of risk over the long-term.

Rick has a plan to travel overseas for an extended period and will need to have ready access to his savings.

Rick classes himself as a short term investor as he wants to spend his money within the next 3 years, and also wants to protect his capital for when he returns to ‘normal life’.

A high interest savings account may be considered as it carries the lowest risk.

Jock and Regina have both retired and are relying on their investments to provide them with money to live on. They need regular, consistent income.

They looked into savings accounts, but the interest rates can go up and down, and they risk their capital being eroded by inflation. Shares generally only pay dividends twice a year and there’s no guarantee of a dividend at all…so they decided that an account-based pension or annuity may suit them better.

Determine your risk profile