Understanding Investment Risk

To invest successfully, you need to assess your own attitude to risk when you start out, then regularly reassess in the light of your changing (hopefully improving!) circumstances. You can do this with your investment adviser, but if you want to be guided rather than led, you can do it on your own and I hope that this article will give you a few pointers.

Most peoples' attitude to risk is defined by two of the basest human emotions, greed and fear. Greed drives the profit motive while fear of losing capital reins in the level of risk we're prepared to take. The problem is that attitudes not only differ when it comes to how much risk we should take, but also about what risk means to different people. For instance, an aggressive investor might view buying individual shares or 'direct equities' as being moderate risk and see futures and options trading as high risk. While a more conservative investor might see direct equities as being a high-risk strategy and would prefer diversified investments like mutual funds, which they would define as moderate risk. This divergence of opinion exists not only between individuals, but also between investment advisers; so what common standards exist?

The most accurate are those used by the investment industry and the best known measures of risk are 'Standard Deviation' and 'Sharpe Ratio'. These are specific and excellent for comparing relative performance and investment volatility. However, for many private investors they are just two more terms used by professionals to confuse the man in the dori!

In the 'real world' a set of broad categories is probably more useful and those below are straightforward and provide common ground for private investors and investment professionals.

0 - No Risk
"I do not wish to take any risk with my investments" (example: Bank Deposits)

1 - Conservative
I am seeking secure investments where the risk of capital or income loss is low, even though this may limit the potential for future grown¡± (example: With Profit Bonds or Guaranteed Investments)

2 - Balanced
wish to invest my capital in investments, which over the medium to long term, aim to both outperform 'conservative' investments (above) and to drop less in falling markets than 'market risk' investments (below)." (For example: Managed Fund, Discretionary Portfolio or Fund of Funds)

3 - Market Risk
"I wish to invest in asset based investments whose overall volatility and riskiness, that is the size of movements, up or down, is broadly equivalent to my 'home' stock market(s)" (For example: Pan European Funds for an Euro Investor, Hong Kong Funds for a Hong Kong Investor, US funds for a US Investor, Low Volatility Hedge Fund)

4 - Adventurous
"I would like to invest in fund which may be more volatile than my 'home' stock market(s), possibly because of currency risk, with the aim of achieving higher returns." (For example: Smaller Company Unit Trusts, Pan European Fund for a US Investor, Emerging Markets Fund, High Volatility Hedge Fund)

5 - Speculative
"I am prepared to invest speculatively, with the risk of a substantial loss of investment, in return for the opportunity of achieving significantly higher returns" (example: Peripheral Stock Markets to your 'home' stock market and Direct Share Purchase)

You may be surprised to see that direct share purchase is viewed as strongly speculative, since many individual stocks are subject to much greater swings in value than collective investments such as mutual funds.

These categories aren't perfect. Some would say that bank deposits don't have 'zero' risk since banks can, and have, gone bust. This is particularly pertinent here in the current climate in Japan. While many investments that carry a capital guarantee should be considered 'conservative' rather than 'zero risk' as there is no guarantee of making a profit, simply a return of capital. The true value of which will have been eroded by inflation.

Of course, there is no need to invest in only one category - a diverse portfolio will have a mixture of assets and have an average risk profile corresponding to any one of these categories.

There are two other factors, which define risk: currency and time.

Currency

As soon as you overrule a single 'base' currency approach and invest in assets denominated in a second, you are increasing your risk. This is covered under the 'market risk' and 'adventurous' categories, both of which indicate that if you invest outside your home stock market, the risk increases. In the lower risk categories, investing in a second currency will raise the risk factor to the next level. After all, if you are a US Dollar investor and invest in a Euro bank deposit, you stand to lose if the Euro weakens. Conversely, if it strengthens, you win - but you have introduced more uncertainty and therefore more risk to your portfolio. The rule of thumb is simple, to minimize risk, invest in assets which are denominated in the currency in which you intend to spend the proceeds - for most expatriates, this is our home country or retirement destination. There is an exception, if you're unsure or going to be internationally mobile, then it does make sense to diversify your investments between the major trading currencies.

Time

Generally, the longer the term of an investment, the less risk is involved. An adventurous or speculative investment held for the long term should even out the peaks and troughs of the investment market. However over a short time frame, perhaps less than 5 years, a greater risk is run.

Finally, having quantified your own attitude to risk and defined your currency and investment timescale, you need to identify and match the risk levels of the investments you are considering to your own. Fortunately, most fund management groups and insurance companies are required by their regulators to state the level of risk attached to each of their funds and they should slot into the categories above. Although I strongly suggest that you seek qualified advice when formulating or reviewing your strategy.

Choose your investments very carefully, particularly if you are considering a small or little known fund manager and always do some of your own research to verify what you¡¯re being told. A small minority of organisations 'oversell' investments and disguise the level of risk you may be taking, while exaggerating the potential for profit. You'll be surprised what you can find out from five minutes on the Internet. If you are unsure what level of risk you are taking with your existing savings and investment plans, ask your adviser to give you details on each individual fund that you hold.

Failing to balance 'greed and fear'has been the downfall of many amateur and expert investors and in my experience; there is one overriding rule when it comes to making investment decisions. If you are uncertain how much risk you should take, always let fear be the arbiter of your decision, not greed.

Ivan Doherty
ipd@ifg-asia.com

Ivan Dohety MLIA (dip) is Chief Operating Officer of IFG Asia. Part of The IFG Group PLC and registered with the Ministry of Finance in Japan to give investment advice.

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