Dealing with Risk

All investments carry a degree of risk, as many investors have learned the hard way over the last few years.  Even bank deposits are not risk-free. Hundreds of millions of dollars were lost in these in the United States over the past few years, and banks are still collapsing there.

Here in New Zealand the tax payer has assumed massive losses in some finance companies that had the Crown Guarantee. Those investors who still have money in finance companies covered by the scheme have only a few more weeks of worry free investing. For Treasury, the next few weeks could be a major worry. The question they will be asking is, will South Canterbury go into receivership?

During the ‘tech wreck’ in the international share market between 2000 and 2003, many investors cashed up and sought refuge in fixed interest investments, believing them to be safer than shares.  Money flooded into finance company debentures and unfortunately many investors failed to realise that there are still risks with these investments; it’s just that they are different risks than with a share portfolio. 

Again in 2007, many investors purchased bonds or redeemable preference share or perpetuals. Typically the capital value of these fell by around 26%. Some have failed, while others have languished at low prices as the interest rates that they are paying now are well below market rates. This may be because at the time of issue, margin levels for credit were a lot lower than they are now.

Looking at fixed interest investments for example, some of the risks that you might face are:

• Your interest payments are made late, in part or not at all.
• Your principal is repaid late, in part or not at all.
• During the investment term, market interest rates increase significantly meaning that your investment is now earning a lower return than the market.
• At the end of the investment term, you find that interest rates have dropped and you will earn less on reinvestment.
• Your investment cannot be sold or redeemed before maturity either because there is no market for it or there is a market but no buyers.
• Inflation increases significantly during the term of the investment, and eats into your returns.
• The industry or companies to which your funds are lent suffer a downturn, increasing the risk of default.
• A significant issue, such as a credit squeeze or an economic recession, increases risk across the board for all fixed interest investments.

While this all sounds very gloomy, there are several steps you can take to minimise the risks you face.  The most obvious of these is to diversify.  Divide the amount you have to invest into a number of smaller parcels.  Set an exposure limit on any one type of investment.  But remember, if one investment fails, typically other similar investments may also be adversely affected.

Think about how much risk you are willing to take and invest accordingly.  If you are a conservative investor that probably means finding investments that have a good credit rating from an internationally recognised rating agency.  If you choose to place your funds in unrated investments, be prepared to do some research that will help you assess the risks involved. 

In an environment where interest rates are expected to rise, it may be prudent to invest via a well managed low cost PIE fixed interest managed fund. We would recommend seeking professional qualified advice over how best you should invest to meet your needs.