INTRODUCTION TO INVESTMENT RISK

Investment risk refers to:

• an uncertain rate of return from sources of income
• an uncertain market price for an asset or uncertainty of return of capital

The taking of risks is often a balancing of the emotions of fear and greed. Risk is not necessarily bad as long as the investor appreciates the possible outcomes. In general, the higher the expected return, the less certain it is that those returns will be achieved. Peace of mind is often of greater importance than the potential of higher returns.

Most investors make a conscious decision to avoid risk unless they are properly compensated. Higher risk investments generally offer higher expected yields in order to attract investors. Investments offering extremely high expected returns should be regarded with a great deal of suspicion.

As high-risk investments are accompanied by higher expected returns, so low-risk investments tend to be accompanied by low expected returns.

Investors can manage investment risk and improve investment decision making by having an understanding of the different risks inherent in various types of investment.

WHAT DETERMINES THE INVESTOR'S ABILITY TO TAKE RISK ?

The capacity of an investor to accept uncertain returns ie., investment risk, depends on a variety of variables peculiar to each individual. These include:

• age
• income and salary levels
• financial responsibilities
• personal attitudes and experiences
• amount and types of other assets owned
• the timeframe for investing eg., less than 12 months - more than five years

GENERAL OR MARKET INVESTMENT RISKS

These risks affect all types of investments and are usually a result of market forces. More specifically they are :

Purchasing Power or Inflation Risk
Purchasing-power risk refers to the uncertainty of an investment's real rate of return as a result of inflation: in other words, that increased prices for goods and services will reduce an investment's real value. Moreover, expectations of higher inflation push interest rates up and asset values down at the same time as higher prices for goods and services reduce purchasing power.

Interest Rate Risk
Interest-rate risk refers to the uncertain returns caused by uncertain market rates of interest. The risk to the investor is that changes in interest rates will adversely affect an investment's return during the period that the investment is held. Variables that affect both short-term and long-term interest rates include:

• government budget deficits or surpluses
• the level of economic activity
• balance of payments deficits or surpluses
• the Reserve Bank's monetary policy which is manifested by rises or falls in official interest rates.
• virtually anything that can influence investors expectations regarding inflation.

SPECIFIC INVESTMENT RISKS

These risks relate to events or circumstances that impact on specific investments or particular types of investment and include:

Business Risk
Business risk refers to an investment's uncertain returns due to the uncertain business environment in which the organisation operates. A poor performance may be the result of unwise management decisions or inefficiencies in the delivery of products or services. It may also be caused by events external to the organisation, such as:

• change in the value of the Australian dollar relative to other currencies
• the possibility that a new competitor will emerge and reduce the organisation's market share.

Financial Risk
Financial risk relates to an investor's uncertain rate of return because an organisation may be unable to meet its financial obligations. These obligations generally consist of interest and principal payments on borrowed funds.

Liquidity Risk
Liquidity means the ability to turn an asset into cash and to do so without being required to significantly reduce the selling price below its current level. Virtually anything can be sold at some price. Liquidity risk refers to an investor's uncertain return because of the possible difficulty in selling an asset.

Reinvestment Risk
Reinvestment risk relates to an investor's uncertainty concerning the return that will be earned on the reinvestment of funds from an existing investment. These funds may result from periodic cash payments made to the investor, or they may result from a return of an investment's principal. Unless the return from investments is used for consumption, cash flows must be reinvested at whatever rate of return exists at the time of reinvestment

Reinvestment risk is a special concern for someone who invests to generate a stream of periodic income payments. Retirees who depend on investment income to pay for living expenses are hard hit if an investment is renewed at a substantially reduced rate of return.

Market Risk
Market risk is the uncertainty of return arising from:

• cyclical market movement e.g., boom and bust cycles, and inflationary and deflationary cycles
• sudden market movements; and
• changes in preference for different investment vehicles.

MANAGING INVESTMENT RISKS

Fixed Interest Investments
The major risks associated with fixed interest investments include:

• the potential for reductions in purchasing power due to price inflation.
• uncertainty with respect to future market rates of interest. Rising interest rates can significantly reduce the market value of existing fixed- income investments.

Both purchasing-power risk and interest-rate risk can be reduced by selecting short-term, fixed-income securities. Short-term investments mature in such a brief time that it is highly unlikely that either inflation or higher interest rates will prove to be a real threat to the expected rate of return. The shorter the term of the investment, the less the uncertainty of returns of unexpected changes in inflation or interest rates.

Investing in securities issued, or guaranteed, by governments or other secure institutions best guards against business risk and financial risk.

Liquidity risk can be eliminated by avoiding fixed-income investments that have an inactive secondary market or, in some cases, no secondary market at all.

A method of balancing the lower return suffered by short-term securities and the higher risks inherent in most long-term, fixed-income securities is to stagger or spread maturities. As short tem bonds reach maturity, funds can be reinvested in bonds of longer maturities that offer higher yields. Laddering maturities permits an investor wishing to own fixed income securities to avoid most types of risk, as long as the bonds purchased have been issued by a diverse group of organisations.

Investing in Shares
An investment in shares (sometimes referred to as 'equities') can provide a degree of protection against inflation. Companies are often able to produce additional profits during periods of general price increases and shareholders may benefit from increased cash distributions and higher share prices. The transformation of general inflation into increased profitability depends on a variety of considerations such as the ability of a firm to pass price increases along to customers and the kinds of inputs used by the firm in producing goods and services.

While providing protection from inflation, shares are nevertheless a relatively volatile investment, that is to say, share prices can fluctuate substantially. Dividend payments frequently change and companies sometimes go out of business. Their products may become out of date, the economy may suffer a serious reversal, or interest rates may increase dramatically. Interest-rate, financial, business, and market risk are all uncertainties with which most shareholders must cope.

However, portfolio diversification and a careful selection of companies in which value can be discerned can greatly reduce these risks and the possibility for capital growth far outweighs that of all other kinds of liquid investments.