What is risk identification?
When you invest in assets there is always the chance that things can go wrong. It is necessary for us to know what the potential risk associated with each asset class is. This allows us to analyse and mostly mitigate the risk. This is called risk identification and management. There are three general risks associated with investing, losing everything, long-term underperformance and volatility.
Risk happens in all facets of the finance industry. When someone adds a stop-loss order to a share position, moves their money into cash investments or transfers money out of the country during uncertain times. These are all examples of risk management (whether it is always rational is debatable). So when we estimate performance, we should weight this against the associated risk.
Risk identification in each asset class
When you invest in cash products, it is generally accepted to be a risk-free investment. Some of the balanced funds even balance the risk with cash investments. The reality, however, is that there is no such thing as a risk-free investment. Banks can fail and have failed in the past (numerous times). In the last 30 years, that has happened 20 times in South Africa alone. Most recently, you will remember African Bank and VBS. Interestingly African Bank went bust in the ’90s as well.
When this happens investors will lose most or all of their investments. Governments in South Africa do not bail out bank anymore (with a few exceptions). In some other countries banks take out insurance for funds invested with them, but this is not the rule. This means that with cash investments you have the risk of losing all of your money (or a large portion).
The typical performance of cash investments ranges between 6% and 10%. You can read more about fixed savings rates in my article South Africa’s best savings interest rates. Compared to other investment categories, this is on the lower side. Less established banks will typically yield better interest rates to entice new customers, but with this comes greater risk as well. Cash investments, therefore, suffer from a risk of long-term under-performance.
On the plus side, the returns from cash investments have low volatility. In other words, the return is predictable and this is what makes it such an attractive investment for most people. When doing cash investments, it is important to look at the finances of the bank you are investing in. Keep doing this regularly to make sure you are not invested in a bank that is on the verge of going bust.
Bonds, more specifically government bonds, are a structured way of lending money to a government. Depending on government debt, inflation etc., bonds yield different returns. If a government is shaky, you will get a better return to entice you to lend them your hard-earned savings. This is not different from banks offering loans with ridiculous interest rates to riskier clients.
At the time of publication, South African 10-year bonds yield 8.475%. This is similar to the yield of cash investments. As a result, bonds are also subject to long-term underperformance risk. Governments typically don’t default on their debt since they can devalue their currency to pay their debt. However, most governments have defaulted on their debt sometime in their history.
When a country defaults on their debts, one of two things usually happen. The debt is restructured by extending the loan period or the currency is devalued to make the debt more affordable. Although this has a massive effect on the country’s economy, the investor should not lose the entire investment. However, the long-term real return might be affected. The low volatility of bonds is also what makes them attractive.
Preference shares from a company are similar to bonds but borrow money to companies for fixed dividends. The yield is comparable to bonds and the volatility is relatively low when compared to shares. The main difference in terms of risk is that the company cannot print money as with government bonds. These dividends are then in arrears and must be paid before paying any other dividends. However, you have the option of buying an ETF that contains multiple preference shares like the Preftrax from Coreshares. This limits your exposure to one company and diversifies your risk.
The return from properties is similar to shares if you manage to keep the property occupied permanently. You can read more about why I don’t invest in property in my article why I’m selling my real estate. There are three big concerns with investing in property though. The first is concentration risk. You are entirely reliant on one area’s property growth. One way to mitigate this is to ensure that you conduct a lot of research into the area where you are buying.
Another method to diversify your risk is to stick to investing in Real Estate Investment Trusts (REITs) where you buy shares in companies investing in property. This will diversify your property holdings as each company owns numerous properties around South Africa and the world. What makes this option more attractive is the fact that the property management is done for you.
The second risk is the possibility to lose all your money. When you are paying down your mortgage, you are expected to pay monthly. If you lose your job or your expenses are too high and you cannot pay the mortgage, the bank will take the property. If this sounds unlikely to you, you are welcome to check out the number of properties going under the hammer. The bank only recovers the outstanding bond and you will probably lose your deposit, transfer fees and everything paid down at that stage.
The last concern is volatility. Even though property growth is a slow-moving process, the rental income from property can be volatile. So when owning property it is necessary to anticipate months when the rental income might vary (or be zero).
The biggest risk with shares is volatility. Share prices will fluctuate in the short term, sometimes rather drastically. For this reason, the majority of your portfolio should never be in single shares. The opinions around this vary considerably, but most recommend that less than 30% of your share portfolio should be in single shares. This means that the majority of your portfolio should be in index-tracking Exchange Traded Funds (ETFs). Shares should also be a long-term investment.
On the other hand, the average performance of shares should be in excess of 12%. This means that in the long run, you will outperform most other investment classes. In shares, you can also avoid the risk of losing all your money by not being an idiot. Since index-tracking ETFs hold a massive number of companies, your exposure to one company that is going bust will be minimal. For instance, a company going bust will impact the performance of the Ashburton Global 1200 by 0.08%. Since this ETF holds the biggest companies in the world, a company going bust is also not the rule.
So how do people lose all their money in shares? Well firstly, they hold massive positions on speculative shares in the hope that they will make a turnaround (that never comes). Then they also leverage their portfolio for increased returns. In essence, leveraging means borrowing money to buy shares to increase your returns. So don’t be greedy.
Risk management is extremely important in investing, but you can also be too cautious. Although it is necessary to invest in assets that give stable returns, it is just as important to ensure that you get great long-term performance. For me, this means having exposure to shares in my portfolio.
Even though all investment classes have risk, there are ways of minimising the associated risk. Firstly, risk can be mitigated by diversification. This is especially true when investing in shares and preference shares. By buying ETFs, you spread your risk across multiple investments. If you buy a global ETF and you lose all your money, this can only mean that the aliens are upon us and money is the least of your problems.
In theory, the best way to mitigate the effect of volatility would be to sell during downturns and buy again at the bottom. In practice this is impossible. It has been done by a small amount of anticipation and a massive amount of pure luck. However, I doubt you’ll find a manager that can do it consistently. To quote Fort Minor: “This is ten percent luck, twenty percent skill, fifteen percent concentrated power of will, five percent pleasure, fifty percent pain…” I know I’m using it out of context, but I know you understand what I’m trying to convey and are singing along (can you remember the last line?).
When doing cash investments you need to make sure you are comfortable with the finances of the institution where you are investing your money. I personally prefer having my cash investments in my home loan. This is tax-free returns and no-one is getting a slice of the pie.
Lastly, the best way of mitigating your investment risk is by long-term investment. Returns will fluctuate in the short-term and people will panic. But in the long-term, you will get the return you require to retire in luxury. Just keep adding to that pile of cash until you can’t see the top anymore.
Be safe out there,
Quote of the week“Trust your own instinct. Your mistakes might as well be your own, instead of someone else’s.” – Billy Wilder Click To Tweet
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