Dealing with Risk

All investments carry a degree of risk. Many investors in overseas countries considered their bank investments to be safe, only to lose big time when their banks collapsed. In New Zealand this is unlikely to happen for a couple of reasons. Firstly, our Reserve Bank has a very strong and powerful supervisory role. Secondly our government has indicated that they will effectively underwrite bank deposits with a crown guarantee if it is deemed that there is a need to do so. This maintains a high degree of stability in the financial system. 

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. 

The Securities Commission has a new website (www.looklearninvest.org.nz) aimed at educating investors about investment risk.  This website should be compulsory reading for all investors.  The Securities Commission defines risk quite simply as the chance that an investment will not be as good as you expected or were promised.  Risk applies not only to the return on your investment (such as interest, dividends and growth in value) but also to the principal sum invested. 

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 effected.

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. 

Recent bond issues on the market have not necessarily been rated by a recognised credit rating agency. Indeed many bonds on the secondary market are unrated. Chosing to invest in these unrated investments implicitly implies that you either believe the investment will pay its interest on time, and at maturity it will repay your capital, or that the expected return is so great that you can afford to lose some of your capital. There seem to be very few investments providing a sufficiently high return to justify the underlying risk. As they say, be careful out there!