Dikkii's financial tips #6: Risk and inflation

Welcome to Dikkii's financial tips.

This is a series where I attempt to provide some sort of guidance to financial matters without breaching the Corporations Act by actually providing advice.

It's actually been quite some time since I last posted an update in this series, and since then, I've rejigged the order of my planned modules just a little.

So before I get too far into this series, I thought I'd touch on the single most important concept for any investor.

Risk.

Risk is such a fundamentally important subject, I reckon that it should be added as the fourth R in primary and secondary education. It is that important.

And sadly, a lot of the time, investors just don't get the whole risk thing until it's too late.

We're hearing a lot about risk at the moment.

Take the current credit crunch in the States, for instance. Risk existed there before the crunch just as much as it does now, even if a lot of professional investors failed to properly account for it. The whole concept of sub-prime lending revolved around lending money out to a demographic that was horribly risky in the extreme. So when it all went pear-shaped, there was suddenly a wailing and a gnashing of teeth that told the world that a whole bunch of financial journalists really dropped the ball on this one.

Prior to that, in Australia, we had issues with mezzanine financing when four medium to largish property developers went belly up leaving a whole heap of investors out of pocket.

And, although gaol is certainly beckoning for at least one of the miscreants who ran the show at one of the property developers in question, we don't appear to have learnt our lesson.

So let's have a look at risk, as it relates to investing. Back in the day, risk was really only discussed with my clients while they did their own self assessment as to where they thought they placed themselves on a basic risk profile.

This was a process, I felt, that was open to all sorts of biases and error. I'll go into this some more in a later post when I get round to looking at risk profiling.

Risk is a huge area. I'm sure that it's possible that you could get a subject stream out of it at university, but I'm really going to discuss one risk area in this post.

Specifically Investment Risk. And only the major ones that cover personal investment.

Investment risk really covers a broad area in itself, so I don't see how I'm going to give it justice here, properly, but today, we'll look at some risks that you really ought to be aware of before you go ahead with any type of personal investment plan.

Let's get started.

1. Market Risk.

Market risk is, ironically, the most understood of all investment risks by mug investors. In a nutshell, market risk is the risk that your investment value will suffer due to adverse market movements.

An example of being adversely affected by this risk might be this - you might have bought 100 shares in XYZ Company for $10 each, making a total investment of $1,000. If the share price drops to $9 per share, then you have, on paper at least, suffered a loss of about $100.

I know that many people who will steer clear of the stockmarket for this reason - yet strangely, they don't appear to see it as an issue in the property market. Odd, but I put this down to heightened transparency and liquidity in the stockmarket. If properties were traded on an open and transparent exchange, I think it would be a different story.

Market risk is managed through diversification. One ideally wouldn't just own shares (directly or beneficially) in XYZ, they'd own shares in plenty of companies.

This, of course, does not mean that you're immune to overall market movements. We can manage this a little better by diversifying between markets. This is the reason why people often have property and fixed interest portfolios in addition to shares. And cash - which is not subject to market risk.

Also, market volatility tends to smooth itself out over the longer term. So examine your investment time horizon, and ensure that your portfolio is not inappropriate.

2. Credit Risk.

Credit risk is fairly straightforward in theory. Basically, it's the risk that if you lend money to someone, they're either not going to meet their interest payments, or possibly not pay back some or all of your initial principle.

In practice, it's a veritable nightmare. Credit ratings for some institutions can change overnight, and when someone goes belly up and is unable to pay their investors, you just want to be sure that you aren't going to lose your life savings.

Credit risk affects cash and fixed interest investments, but not property, shares or much else for that matter. But this doesn't make it any less of a concern.

Again, credit risk is best managed by diversification, both by having a diversified portfolio of cash and fixed interest investments, and diversifying into different asset classes such as shares and property.

Credit ratings are certainly useful, but at the end of the day, 20 AAA-rated fixed interest securities are better than one. This is a false dichotomy, (though still a valid statement) but I'm sure that you understand why I'm not mentioning any other possible scenarios, of which there are many.

3. Currency Risk

I just love this one. Where you have an investment in a currency denominated in anything other than the one that you're used to, currency risk is the risk that the exchange rate changes and your investment reduces in value as a result.

Here's a good example. The Australian dollar has appreciated markedly against the US dollar over the past three or four years. Consequently, anyone in Australia who invested in a US dollar denominated asset at the start of that period might be looking at paper losses, if they convert the current value of those assets back to Pacific pesos. Assuming, of course, no (or a small amount of) capital growth in the US dollar value of the asset itself.

There are actually quite a number of ways that investors can use to guard against currency risk. Diversifying your asset base (I know I sound like a broken record here, but chant this one like a mantra, kids) is one. If you have international assets in your portfolio, don't just have ones from one country. Have many from many countries.

It would be rare for investors to have only international assets dominated in currencies other than their own. Most of an investor's portfolio will be denominated in their own currency. This is further diversification.

Lastly, where foreign exposure exists, do be aware that currency hedging exists. This can be offered relatively cheaply - quite a lot of international equity funds have a hedged version and an unhedged one. The hedged version will normally be slightly more expensive, fee-wise, but for additional diversification, you could very easily have some of your international exposure in a hedged portfolio and the rest in an unhedged one.

Note that when people talk about "hedge funds", it doesn't normally relate just to currency hedging, or international equity funds that use currency hedging.

4. Liquidity Risk

Liquidity risk is another that has reared it's ugly head throughout the sub-prime lending and mezzanine finance crises.

Basically, this is the risk you take that you will not be able to cash in your investment quickly either at the end of your investment horizon, or at any other time for that matter. Such as emergencies.

Liquidity risk pops up in a lot of places. Thinly traded shares in small listed companies are heavily subject to it - when you want to sell, will there be a buyer? Term deposits - you can't normally access these until maturity. Superannuation is another - it's no good if you're trying to get access before retirement. Residential property can have settlement periods of up to 180 days.

The best way to manage liquidity risk is to explore each of your assets in turn and know how liquidity risk might affect them. And then come up with strategies to avoid the risk itself taking into account your own personal circumstances.

For example, you could possibly choose to buy shares in blue chip companies that are heavily traded and minimise your exposure to smaller capitalised companies. Use term deposits for money that you know that you definitely will not need until maturity. Use superannuation for money that you know you definitely will not need until retirement. Selling a residential property? Try to negotiate a shorter settlement period if you need the cash, and so on.

The rule of thumb is to know the asset, and how it fits in with your overall plans for the money invested.

And did I say diversify? This helps, too.

5. Inflation

Well, inflation is a right bastard of a thing.

The risk here is a simple one, but overly conservative investors don't understand it very well at all, based on my experience.

Its best explained like this: Imagine that you buy $100 worth of groceries today. If we assume a rate of inflation of 3% per annum, this means that those same groceries will cost $103 this time next year, and about $106 in two years time.

Thus, if we invest in a bank account paying 4% during that period, the return on your funds as measured by the buying power of that money is going to be greatly reduced by that rate of inflation in the meantime. Add in the impact of taxation, and you stand to go backwards, not in dollar terms, but in purchasing power terms.

Again, diversification is the key here. Historically, cash and fixed interest investments have been heavily subject to inflation so it pays over the medium to long term to diversify into investments that have the potential to provide capital growth, such as shares and property.

In the short term, you may have no choice but to accept "losses" caused by inflation. Growth assets are generally considered hot potatoes in the short term.

6. Opportunity Cost

Let's say you invest in shareholding A over a period and that asset returns 6% consistently over that period.

But at the end of that period, you find out that you could have invested in shareholding B instead, which returned 7%. It may be ludicrous to suggest that you could have known about this at the start of that period, so let's just use a statement uttered by sensible investors everywhere whenever they hear about this:

"No one is psychic."

Needless to say, there is no way that you can control for what is, essentially, speculation in hindsight.

Accept your opportunity costs with good grace, and wish investors in shareholding B good luck. You didn't "win" today.

7. Interest Rate Risk

Interest rate risk is simply what might happen due to a rise in interest rates.

Fixed interest is really susceptible to this. Imagine that you have a portfolio of bonds. If interest rates were to rise unexpectedly, this has the disadvantage of making bond yields go up, which really means that your bond portfolio has just decreased in value, all other things remaining constant. In this context, this is another type of market risk.

Indirectly, this can also affect shares and property - companies will find it harder to remain profitable if the cost of their borrowings increases. Property becomes less attractive to buyers if their interest bill is higher.

Conversely, cash becomes more attractive - if interest rates increase, the income from cash investments will normally increase. Likewise also, international assets should increase in value in domestic pricing - all other things remaining constant, a currency's exchange rate with the rest of the world should go up if the central bank of that currency raises interest rates.

Diversification ensures that some of the risk that interest rates might increase is absorbed and also turned to an advantage in spots. Of course, knowing your assets helps as well.

And if you're invested via a gearing strategy? Well, I think you can work out what's going to happen in this scenario.

8. Reinvestment Risk

Reinvestment risk is the risk that your investment might come to an end sooner than you expect.

A good example is if you provide a mortgage to someone to invest in a property, and they pay it back sooner than what you expected. You then have to go ahead and reinvest the money again elsewhere.

Sometimes this can happen with other assets - a company you hold shares in might, for example, be subject to a takeover bid for cash, and you then end up receiving cash for your shares if the takeover is successful.

This can cause problems from a tax perspective.

Diversifying your portfolio will minimise the impact of such events when they occur.

9. Manager Risk

Your investment is subject to decisions made by the manager responsible for your investment's performance.

A good example of this might be where a managed fund (or mutual fund, if you're reading this from North America) that you invest in might suddenly terminate due to a decision by the manager of that investment. You might then find that they've redeemed your investment and you then have to do something with the proceeds of that redemption. This particular example is also a good example of reinvestment risk.

Another one is where the manager changes the methodology by which a particular fund invests. This happens occasionally, and can make it somewhat annoying when you have invested in a particular managed fund for a particular reason - say, for example, the managers's particular investment methodology.

This makes diversification imperative - if your reasons for investing in a particular asset evaporate overnight, or you end up receiving the proceeds of a forced redemption, this can play havoc with your own personal tax planning, particularly if you're relatively highly exposed to that particular asset.

Different fund managers of different management styles is usually considered prudent and is an excellent example of further diversification.

10. Fee Risk

Financial advisers who work on a commission basis will never discuss this risk.

Fee risk is basically the risk that any fees that you incur will reduce returns, and may even reduce the capital invested.

It's best to manage this risk through crunching some numbers yourself to see how exposed a position you find yourself in. I normally suggest taking your amount invested and working out a years worth of fees based on that figure. And then shopping around.

You would be surprised at the figures that you may end up obtaining.

The good news is that your fees might actually be reduced by a market downturn. Of course, we're talking in dollar terms. In percentage terms, they may actually increase as a result.

In addition, fees serve to exacerbate negative returns. Know your fees and how to minimise them.

11. Personal Events Risk and Property Risk

No discussion of risk would be complete without discussion of this. These are the risks that something might happen to you, or your personal property.

This might not directly impact your investing, but can certainly indirectly impact, particularly if you find yourself having to draw on your investments to fund an unexpected personal event.

Always ensure that you have adequate insurance in place covering personal property such as home and contents cover and comprehensive vehicle insurance.

Legal liability insurance is always good - in today's litigious society, you may need it when you least expect it.

Likewise you can't put a figure on the usefulness of private health and term life insurance. Mortgage protection and credit card cover is useful, but not as cost effective nor does it cover for as much.

Travel insurance is something that you should never leave home without.

Lastly, ensure that you have a valid Will and Enduring Power of Attorney in place, or at least accessible if anything happens to you. An Enduring Power of Attorney (Medical Treatment) or its equivalent is also a good idea.

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This list is by no means exhaustive, so don't rely on it being a be all and end all. For more information regarding the risk that you're facing specifically, your adviser should be able to tell you more details.

Just remember, that if you know your risk and how you're managing it, then the return side of things - the sexy bit - should be easier to manage.

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Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.