The Risks You Face as an Investor

Investors are exposed to a host of financial risks. If you know what they are, you can guard against and manage them, and you’ll be more informed when discussing your investments with your financial adviser.

What is risk?

In its most literal sense, financial risk is the possibility of losing money. However, investment experts take a broader view of risk, defining it as the possibility of your investments not performing as expected. This is an important distinction, especially regarding long-term investments, where you and your adviser need to make projections about the value of those investments when, as in the case of retirement savings, you need to start drawing an income from them.

Broadly speaking, there are risks particular to the types of assets you are invested in, wider economic risks that will affect the performance of all assets, and risks associated with you as an individual. They are not mutually exclusive and may overlap or influence each other.

Asset-related risks

Volatility risk: This front-of-mind risk for investors relates to the prices of assets on the financial markets. It chiefly applies to shares, derivative contracts, commodities such as gold, and cryptocurrencies. Because of the up-and-down nature of the prices at which these assets are traded on the markets, your investment could lose capital value or fail to increase in value depending on the timing of buying and selling.

Company risk: For the shareholders of a company, this is the risk of the company becoming unprofitable and possibly failing altogether. It is influenced by factors such as the cost of goods, profit margins, competition, and the level of demand for its products or services.

Credit-default risk: This applies to credit instruments such as bonds. It is the risk of the borrower defaulting on its debt repayments. The borrower may be a government, in the case of sovereign bonds, or a company, in the case of corporate bonds.

Interest-rate risk: If interest rates change – for example, if the SA Reserve Bank increases or decreases the repo rate – returns on interest-bearing investments, such as bank deposits, money market accounts and bonds, will be affected. This is a significant risk to bondholders because, as interest rates rise, bond prices in the secondary market fall, and vice versa. There are knock-on effects on the equity market.

Liquidity risk: This is the risk of not being able to sell an investment when you want to because there is no buyer immediately available. Listed shares, bonds, and collective investments such as unit trust funds have minimal liquidity risk because of the way these markets are structured and regulated. Illiquid investments can include physical property and private equity.

Economy-related risks

Currency risk: This applies to offshore investments, and is often not fully taken into account when people invest offshore, either directly or indirectly via a rand-denominated feeder fund. Over the long term the rand has steadily lost value against major foreign currencies but over the short term exchange rates are volatile, and any appreciation in the value of the rand offsets the returns in rands of the offshore asset.

Country risk: The country in which you are invested, whether it be South Africa or a foreign nation, faces ongoing economic and political risks which affect the performance of its capital markets. If business activity declines, the equity market will suffer. For bondholders, in an economic crisis the government may default on its debt repayment obligations.

Inflation risk: The purchasing power of money is continually being eroded by inflation. Inflation in South Africa is kept reasonably in check by the SA Reserve Bank, whose target range is 3% to 6%. Consequently, investors can be fairly confident in calculating the returns they need to comfortably beat inflation over the long term.

Systemic risk: This refers to the collapse of an entire market or financial system due to the failure of one or more of its parts. The resulting domino effect disrupts and destabilises the whole system. Governments will typically intervene to stem the damage, as they did in the 2008 Global Financial Crisis.

Investor-related risks

Behavioural risk: This is the risk of your behaviour as an investor affecting your investment outcome, and it is one over which you have full control. Risky behaviours include not saving enough, cashing in retirement savings when changing jobs, not allocating enough to inflation-beating investments such as equities, and trying to time the markets.

Concentration risk: The fewer the number of underlying assets you are invested in, the greater the damage wrought by the failure of any one of them. Diversifying your investments is crucial in not only reducing the impact of individual failures but in smoothing out your returns, as asset types behave differently under different conditions. (See “Diversification: The Investor’s ‘Free Lunch’”.)

Longevity risk: This is the risk of living longer than expected and needing your retirement savings to sustain you for longer. In planning with your adviser, it’s a good idea to err on the side of a longer life, considering that population trends are in that direction.

SOURCES:

https://www.fnb.co.za/for-me/save-and-invest/risks-to-consider-when-investing.html

https://www.smartaboutmoney.co.za/saving-and-investing/investment-basics/what-do-i-need-to-know-about-investment-risk

https://www.investopedia.com/terms/r/risk.asp#toc-types-of-financial-risk