What does risk have to do with investing?
Every investment has risk.
Risk is the chance that an investment will not be as good as you expected or were promised.
It means that you might not get your money back and you might not get any additional returns (e.g. interest or dividends or capital growth).
A common saying about investment is "the higher the promised return, the greater the risk". Experienced investors know that exceptions to this rule are rare, and for most investors it is a good rule to follow.
Deciding on the level of risk that you are comfortable with is an important part of choosing investments that are right for you.
Everyone has different levels of comfort or discomfort about risk.
Knowing your risk profile will help you decide what investment risks you are prepared to take and what investments are right for you. You can assess your risks at www.sorted.org.nz
Types of risk
There are many kinds of risk.
Some risks apply to all investments - e.g. if the whole market for investments falls everyone's investments will fall in value. This occurred during the recent global financial crisis.
Some investments have risks specific to them - e.g. your shares in a timber company would fall in value if the world price for wood falls.
Every investment has its own risk - this is why it is important to find out about the risks of each investment you make.
Other risks
Some other types of risk are:
- Capital risk - the investment fails and you may lose all your money.
- Interest rate risk - interest rates might change during the term of your investment. For example, you lock in your money for two years at 5% interest. After one year interest rates rise, so you don't earn as much interest for the second year of your investment as you would if you'd been able to invest at the higher rate. Of course, the reverse happens when interest rates fall.
- Liquidity risk - the risk that there might not be many buyers for an investment you want to sell. You may have to wait for a buyer, or sell at a lower price.
- Credit risk - the risk that a company you buy an investment from may not be able to repay its debts. It may default on the money it owes you.
- Industry risk - the risks that can affect a particular industry, such as shortages of raw materials, changes in consumer preferences, or loss of an export partner.
- Currency risk - the risk that a company you invest in is affected by changes to the currency e.g. if the New Zealand dollar increases in value an importing company's share price might rise because it can buy more goods for fewer dollars. On the other hand an exporting company will get fewer dollars for its goods, and its share price might fall.
- Inflation risk - the risk that your investment (e.g. a bond) does not earn enough interest to keep up with inflation. If your bond is earning 2% per year and inflation is 3% a year your bond falls in value over time.
Should I consider putting money into more than one investment?
Putting all your money into just one investment breaks an age-old rule of investment - "don't put all your eggs in one basket".
Putting your money into several investment types reduces the effect on your combined investments if there is a downturn in one investment type. It's called diversifying.
For example, you have some shares and some fixed interest investments. The interest rate falls, so when your fixed interest investments come up for renewal you may have to settle for a lower rate of interest. However, the value of your shares may not be affected in the same way.
If there is a downturn on the sharemarket, although the value of your shares might fall, your fixed interest investments may not be affected.
Buying several fixed interest investments with different terms is diversifying over time. However, to have the full benefits of diversification it would be better to buy several different types of investment.
