Risks

Risk is a word that is used continually in financial circles and most people see risk as meaning that they might lose all their money! The fact is that every investment has some risk and the key is to understand the risks so that you can weigh up the pro’s and con’s of each investment type and then put into place a strategy suitable for your situation.

 Risk vs reward

Successful investing requires an understanding of the basic risk and return relationship. A general investing principle is that investors relate risk and return in the following way:

‘The higher the perceived risk the greater the potential return’

Of course your idea of risk might be completely different to the next person's, so our perceptions of risks as investors aren’t necessarily a true reflection of risks as analysed statistically. This is why it is important to have a clear understanding of your risk profile – more on that topic later.

To keep it simple, think of investments in two broad categories:

Growth assets

Growth assets are usually shares or property and these investments generally have the potential to earn higher returns but carry higher risk over the short term. The rate of return of the investment may vary and the value of the investment may be more volatile.

Defensive assets


Defensive assets on the other hand, provide little chance of capital loss but generally earn a lower return. These types of assets include cash and fixed interest and returns are less likely to fluctuate in the short term.

There are a number of things you can and should do to manage the risks associated with investments. These include, but of course, are not limited to:

  • Making sure your investment strategy meets your investment objectives and financial situation
  • Understanding the nature of the investment you are making
  • Investing for at least the suggested minimum investment timeframe for a particular investment vehicle
  • Regularly reviewing your investment in light of any changing objectives or financial situation

The diagram below demonstrates the risk reward relationship of four of the more common types of investment:

The principle of diversification allows you to spread your investments between more than one asset class to achieve more stable returns and therefore reduce investment risk.

 Types of risk

There are a number of types of risks:

Opportunity risk

The risk of losing the income or earnings you could have made on one investment because you did something else that wasn’t as profitable. An example of this might be if you bought an investment property in the wrong location and you miss out on the capital gain that you could have achieved if you had bought the property in a better location.

Market risk

The risk related to the overall market. If there is a significant market decline then it is likely that there will also be a fall in the price of most stocks. Investors cannot manage market risk with diversification so need to have an understanding of the position of the market and avoid buying into a high risk market.

Specific risk

The risk associated with an individual stock.  Despite careful selection, unanticipated events may cause the stock price to fall after purchase.  Investors manage specific risk by using diversification and by limiting the amount of capital invested in any one stock.

Legislative risk

The risk of the laws changing that may affect your investments. This could be particularly relevant to superannuation because the rules do change regularly. The key to remember here is that the older you are the less likely you are to be adversely affected by legislative changes.

Inflationary risk

The risk of the power of your dollar being less, or to put it another way, the possibility that the value of assets or income will decrease as inflation shrinks the purchasing power of your money. Inflation causes the value to decrease whether the money is invested or not, so it is a stealthy risk that can erode the value of a portfolio year after year. Significant amounts of cash left in a cash account with a low interest rate for long periods would be an example of inflationary risk to a portfolio.

Credit risk

The risk that a issuer of a debt instrument may not be able to make the capital repayment at the end of the period of investment or that they may default on interest payments.

Liquidity risk

The risk that you many not be able to sell the investment at short notice due to the illiquid nature of a particular investment. An example of this would be direct property.

 Your risk profile

We all have different attitudes toward investing risk. Think about how comfortable you are with the possibility of losing money, what your timeframes are and how you emotionally deal with volatile returns. You need to consider investments that balance your appetite for risk with their ability to reach your financial goals. This is a decision that is very specific to you but it is an important one as you want to able to sleep at night. Only you can determine your 'sleep at night' factor.

There are a wide range of tools available to determine risk profile.

Before you start using them remember that risk profiling tools can:

  • Help you understand how you feel about risk
  • Clarify your understanding of your tolerance for risk
  • Provide you with a general illustration of how people with certain risk profiles may choose to diversify their investments

but they will not provide you with any advice. 

Explore the links below to the various risk profile tools.  We suggest you pick a couple so that you can compare results.  Print out the results and then come back here to determine where you might sit in the risk table below.

Risk Profiling

BT Investments

Hesta

Colonial First State

Below is table outlining the more common terminology for risk profiles. Use it as another tool as you understand your own risk profile and develop your own investing skills and style.

Risk profile investment style

Investment style

Your primary investment goal is....

Conservative

Capital protection

You require stable growth and/or a high level of income, and access to your investment within 3 years.

Cautious

Capital protection

You require fairly stable growth and/or a moderate level of income. Your investment term is 3 years or more.

Moderate

Capital growth

You can tolerate some fluctuations in the value of your investment in the anticipation of a higher return. You don't require an income and you are prepared to invest for 5 years or more.

Moderately aggressive

Capital growth

You can tolerate a fair level of fluctuation in the value of your investment in anticipation of possible higher returns. You don't require an income and you are prepared to invest for 5 to 10 years.

 Aggressive

Long-term capital growth

You can tolerate substantial fluctuations in the value of your investment in the short-term in anticipation of the highest possible return over a period of 10 years or more.

 Other risk resources

Here are some links to other resources on risk:

A News website with a light hearted article on risk profiles across generations.

Macquarie has an excellent poster called Understanding Market Risk which shows the long term trends and puts risk in perspective.