15 January 2008

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.



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.

--
Dikkii's financial tips index

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.

9 comments:

Plonka said...

Dikkii:

This is big and I'll need to read it in parts...

Market risk:

If properties were traded on an open and transparent exchange, I think it would be a different story.

My mum bought a house in Essendon in 1973 for $25,850. We sold it last year for more than $750,000. Can I get that sort of a "safe" return on the market just by buying something I look the look of?

So this is where I think the big difference lies. Perceptions. If I buy a house, any house, inside the 10km circle around Melbourne and live in it, history shows that I can expect to double my money (at least) inside a 10 year period. If on the other hand, I had invested that money in stocks, any stocks, on the market, history shows that I take my chances.

So the perception is "safe as houses", no diversification required...

Credit risk:

Credit risk affects cash and fixed interest investments, but not property

I don't get this bit Dikkii. I was subjected to a rigorous credit risk assessment when I applied for my mortgage.

about $106 in two years time

About 9 cents more than that in fact (rounded up to 10 of course) and it just get's worse and worse, especially if you don't get CPI increases. Add that up over 6 years or so and you run smack dab into my little problem.

Interest rate risk:

This one's a kicker ain't it? When I took out my mortgage, a mortage broker tried to convince me to buy a house worth double the one I bought, simply because at the time I could afford the repayments (these are the guys we don't talk about that I alluded to in a recent post, and he was very convincing).

But being smarter than that, I wanted to make sure the interest rate (about 6% at the time) could increase by a magnitude (to about 16%) and still be affordable, before I'd commit. I was told I was being silly and that interest rates would never again be that high. IOh how I laughed....

Over time, what with the general effects of inflation, that I didn't take into consideration at the time, and no CPI increases since I bought, my buffer has been erroded down to about 11 - 12% and it gets smaller with every announcment and I get more worries with every announcment.

Now, I'll have to come back to the rest Dikkii, I've got things to do. Great post though...:)

Dikkii said...

G'day Plonka,

My mum bought a house in Essendon in 1973 for $25,850. We sold it last year for more than $750,000. Can I get that sort of a "safe" return on the market just by buying something I look the look of?

Plonka, this is a 25 year period. You'll recall that I also wrote this under 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.

There is, not to put too fine a point on it, significant market risk in property. And as you wrote:

...history shows that I can expect to double my money (at least) inside a 10 year period.

10 years is normally considered to be "long term".

But I would have appended the words "on average" to your statement because of this: Some time in 2001, there were some figures published in the Age showing that, on average, across Melbourne, if you had purchased a residential property in February 1991 and sold it in February 2001, you would have sold it for less than what you bought it for.

The main reason for this was the property slump of the early 1990's which hit Melbourne worse than the rest of Australia. Also, on average takes into account suburbs like Broadmeadows and Keysborough (particularly badly affected by the slump) which are also suburbs of Melbourne too, just like North Fitzroy and Carlton (which shrugged off the effects of the slump relatively quickly).

If on the other hand, I had invested that money in stocks, any stocks, on the market, history shows that I take my chances.

History does not show that at all.

Picking stocks out at random eventually approximates a stockmarket index.

Picking one stock at random could be anything, but again, statistically, the index is by definition your expectation, subject to a couple of assumptions. This is just plain irresponsible, so we can (happily) dispense with that scenario.

Keeping that in mind, let's look at the All Ordinaries index over that same period:

1 February 2001: 3291.5
1 February 1991: 1319.6

That's about double and a half.

So the perception is "safe as houses", no diversification required...

Property is not subject to the same degree of volatility as the stock market, this is true. However, portfolio theory tells us that unless you're wealthy enough to own a stable of properties, or you have an ultra-aggressive risk profile, one or two properties does not adequate diversification make.

Particularly if, say, soil contaminents were found at your investment property.

I don't get this bit Dikkii. I was subjected to a rigorous credit risk assessment when I applied for my mortgage.

I've been discussing investment risk and how it applies to assets, specifically. A mortgage in this context is not an asset, but a liability.

In this context, you're not subject to credit risk. The institution lending you the funds is. Their credit assessment is their way of determining more or less how much credit risk you are going to cause.

To put this another way: your mortgage is, in essence, someone else's fixed interest investment. And thus, they've assumed that risk, not you.

The risk that you've assumed is not really credit risk per se, it's more of an affordability risk.

It's also a borrowing risk, not an investment risk.

...I get more worries with every announcment.

We all do Plonka. Once upon a time, I would have suggested to people to base their home loan affordability calculations on an interest rate of about 9 or 10%. I once also though that this was unrealistic, but conservative.

This is looking increasingly realistic as rates keep going up, so I think that 12-15% is probably a better guide, now.

Dikkii said...

Just re-read this:

Picking stocks out at random eventually approximates a stockmarket index.

Picking one stock at random could be anything, but again, statistically, the index is by definition your expectation, subject to a couple of assumptions.


I should point out that picking many stocks out at random is just as irresponsible as picking one out.

Don't do this. Do it properly.

And if you don't know the proper way, speak to an adviser.

Plonka said...

I was just talking about a "perception". I work with a guy that goes on and on about doing (and he already has three properties) just exactly that. I try to tell him it's only a perception but because I have antiquated ideas about finance, he won't listen to me, which is fair enough I guess...:)

I know all about the All Ords because I like to watch Allan Kohler, his delivery is first class...:)

Once again though, it's merely a perception and doesn't need to be true.

I've been discussing investment risk and how it applies to assets, specifically. A mortgage in this context is not an asset, but a liability.

Yeah sorry, I neglected the smiley face...:)

so I think that 12-15% is probably a better guide, now.

Couldn't agree more. *sigh*....

Dikkii said...

I try to tell him it's only a perception but because I have antiquated ideas about finance, he won't listen to me, which is fair enough I guess...:)

It's a perception that a lot of people have.

Sadly, it's also the perception that allows property gurus to operate their own unique brand of financial woo.

Einzige, who's blog I read from time to time is one who is fighting the good fight against these arseholes.

But, you know, your colleague could do far worse than to listen to Alan Kohler himself. I think that Kohler is excellent.

Plonka said...

Sadly, it's also the perception that allows property gurus to operate their own unique brand of financial woo.

Henry Kay was my favourite and because we all have specific nick-names at work (I'm Willie from The Simpsons) "Henry" is what we all call that particular colleague...:)

Dikkii said...

Henry Kay, eh? I wonder what happened to him. Did he end up going to gaol, or just getting fined? Or is the case still in progress?

And "Willie"? No doubt that's your Scottish heritage coming through there, Plonka.

Plonka said...

He ended up in gaol and our illustrious up and coming property tycoon at work was the butt of many a joke because of it...:)

No doubt that's your Scottish heritage coming through there, Plonka.

Yep, and my general attitude toward life tops it off nicely. We also have a bloke that is the spitting image of G. W. Bush, the poor bastard, one that's the "comic guy" from The Simpsons, Arpu, "Disco Stu" and many more. We try to stick with a Simpsons theme, but it doesn't always work.

As they say, "We don't make a lot of money, but we have a lot of fun"...:)

Now where was I...

Reinvestment risk:

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

As some are no doubt discovering, even as I type. Worst downturn ever apparently...

Manager risk:

might suddenly terminate due to a decision by the manager of that investment.

Or the manager leaves that particular institution. But when I was at Mercury, they managed that risk for you. There was some kind of jiggery-pokery they performed, holding the funds in trust or moving them to another fund or something.

This happens occasionally, and can make it somewhat annoying

"Somewhat annoying" ain't the half of it. Do you have any idea what the IT guys have to do when a fund manager decides he/she wants to leave? I had to go to people's houses (and some of those were magnificent) and remove equipment and financial feeds (Bloomberg, Reuters, Iris, etc) we'd supplied.

Dikkii said...

He ended up in gaol and our illustrious up and coming property tycoon at work was the butt of many a joke because of it...:)

I feel bad, but I admit to having felt a certain sense of schadenfreude when they originally arrested Kaye.

There was some kind of jiggery-pokery they performed, holding the funds in trust or moving them to another fund or something.

The larger fund managers are in a position to do this. This is kind of ironic when you consider that it gets very difficult for a larger fund manager to adhere to the investment rules that they might have laid down for a particular fund when they were smaller.

As some are no doubt discovering, even as I type. Worst downturn ever apparently...

I wish I had some money to invest.

"Somewhat annoying" ain't the half of it. Do you have any idea what the IT guys have to do when a fund manager decides he/she wants to leave? I had to go to people's houses (and some of those were magnificent) and remove equipment and financial feeds (Bloomberg, Reuters, Iris, etc) we'd supplied.

That's amazing, Ted. Most of the fund managers that I've known usually spend their whole lives at work.

What I would do for having that kind of connection, though.