Friday, July 11, 2008

What is investment risk?

All investments have some form of associated risk: they all expose you to the chance you could lose money (either notionally or permanently). Here are seven of the more common types of investment risk.

  1. The risk of permanent loss of capital. Poor quality investments usually experience falls in their value from which they never recover. In extreme cases, their value can fall to zero.
  2. The risk of volatility. Investment volatility is the risk of the value of your investment moving up and down. With high quality investments, their values should move up more than they go down.
    Investments which are expected to produce higher long-term returns (such as shares) tend to
    experience higher levels of short term volatility. On the other hand investments which are expected to generate lower long-term returns (such as bonds) usually experience less volatility in the short term.
  3. Wealth risk. This is where your investments do not generate sufficient returns to help you achieve your wealth or retirement objectives. This is typically the case when a person chooses not to employ an asset that has a higher level of investment volatility (and also a potentially higher return). In that case, the person will need to lower their wealth or retirement expectations.
  4. Credit risk. Credit risk usually applies to fixed term investments and means that the institution you have invested with may not be able to make the required interest payments or repay your money.
  5. Inflation risk. This is where your money loses purchasing power because your investments do not keep pace with inflation. Cash is a good example of an investment that usually falls prey to inflation risk.
  6. Liquidity risk. Investments which are fixed term expose you to liquidity risk. For example, if you need to access your money from fixed term investments before the term expires, you may be prevented from doing so under the contract. Or, if you can access your money, it might take longer than you want, and/or you may be charged significant penalty fees. Poor quality share and property investments also expose you to liquidity risk. The risk is that no one will want to buy them from you or will only buy them at a substantial discount.
  7. Currency risk. When you invest overseas, your money is usually converted to the currency of the country in which you invest. If the Australian dollar subsequently rises in value compared to the other country’s currency, your investment will be worth less to you. On the other hand, if our dollar falls in value, your investment will be worth more.

How can you manage investment risk?

Investment risk can be managed using three prudent principles of investing:

  1. Only invest in high quality investments.
  2. Construct a properly diversified portfolio.
  3. Regularly review your investments to ensure they continue to maintain their quality

Talk to a qualified financial planner about the best way to invest and manage risk associated with your investments

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