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Understanding Investment Risks


What is investment risk?

For an investor, risk refers to the degree of uncertainty and/or potential financial loss ingrain in an investment decision. In other words, investing your money without knowing if you will receive the desired returns or experience unexpected losses.

So why risk it instead of stashing your money away? Risk may help you earn a return on the investment; and seeking higher returns may mean accepting greater risk.

If you want to give your money a greater chance to grow, getting comfortable with risk may be a good idea. However, the level of risk you take on is up to you.

If short-term changes in the value of your investments do not bother you, you’re probably fine taking on some amount of risk. However, if the thought of a drop in value – even for one day – gets you worried, then taking less risk might be more your preference.

If you are investing for long-term goals, it is difficult to eliminate risk while earning a potential return on your investments.

Common investment risks

While there are many types of potential risks your investments could face, you should know of the most common ones that can cause you to miss your financial goals.

Market risk

This is where various market forces and economic events dictate how your investment performs. You could plan to beat the market, but overall, your returns will be reliant on how the markets move. And generally, they tend to move along a cycle of bear and bull markets.

It is important to note the difference between market volatility and market risk. Volatility is how frequently and significantly an investment changes price over time, while market risk is the probability that a change will result in permanent or long-lasting loss of value.

Bear vs Bull market: What does this mean, and which one is moving up or down?

Bear market

This refers to a period of two or more months with declining stock prices and negative investor sentiment. In general, stocks should be down by at least 20% during this time for it to be a bear market.

Bull market

The term refers to when markets are on the rise. In general, markets are bullish while stocks or other investments are gaining value. Bull markets have been known to last for many months or even years. The most recent bull market lasted from 2009 to 2019, where the S&P 500 gained a whopping 472% over 10 years.

Interest rate risk

If you’ve invested in bonds and debt securities, you could also be affected by changes in the overnight policy rate (OPR). The value of your bond moves in the opposite direction of the interest rate. If rates go up, your investment loses value.

This is because your bond has a fixed return at the moment it was created. When interest rates go up suddenly, newer bonds will now have greater future value than yours, which means that it will be less desirable if you want to sell it before it matures.

Example
You have a bond with a 3% return on it. However, the OPR has increased, and the interest rate is now 5%. Your bond is now worth less because the market is now offering bonds with a higher return, and hence people will offer you less money for your bond if you are looking to sell it. So it is better to wait until it matures.

Inflation risk

Rising costs of living are guaranteed to impact the value of your investments. This is due to the overall value of a single ringgit falling over time. Inflation will always eat into the value of your investments, but moderate inflation risk is usually viewed in a positive manner.

Inflation risk, on the other hand, might significantly diminish your purchasing power over time. For example, in the mid-80s, a popular fast food restaurant cost RM3, but now it costs RM11.31. To afford the same burger, you would have to raise your purchasing power by 377 percent over 40 years.

As many investments are intended to be long-term, you should always compare your rate of return to the annual inflation rate. Returns that are lower than inflation may look like they are growing, but they are not doing enough in practical terms.

Foreign exchange risk

Investing in foreign markets runs the risk of the currency being devalued. You could see a significant decline in your profits if the exchange rate changes drastically.

For instance, your investments in the US dollar could see a 10% return over the next five years, but that would mean little if the exchange rate between the US dollar and ringgit drops by 10% over the same amount of time.

Liquidity risk

The only real way to realize gains you make from investments is to successfully sell them to a willing buyer. This may not always be the case if you have invested in equities that are less desirable or have seen demand drop. In other words, you will not get returns from your investments if nobody wants to buy them.

This is a risk that is significantly higher if you are investing in small companies that may see higher growth in terms of stock price but may not have anyone willing to buy them later.

How to manage risk

The first thing to do is to stay calm. There are many ways of limiting your risks, most of which are within your control.

Know your risk profile

The second thing to do is to understand your risk profile. How much risk are you willing to take on while investing? Are you prepared to make a loss on the investment? How long do you have until you reach your investing goal?

Conservative This allocation is designed for the more cautious investor, one with sensitivity to short-term losses and/or a shorter time horizon. It is targeted toward the investor seeking investment stability from the investable assets but still seeking to beat inflation over the long term. The main objective of this investor is to preserve capital while providing income potential. Investors may expect fluctuations in the values of this portfolio to be smaller and less frequent than in more aggressive portfolios.
Moderate conservative This allocation may be appropriate for the investor who seeks both modest capital appreciation and income potential from his or her portfolio. This investor will have either a moderate time horizon or a slightly higher risk tolerance than the most conservative investors. While this allocation is still designed to preserve capital, fluctuations in the values of this portfolio may occur from year to year.
Moderate This allocation may suit the investor who seeks relatively stable growth with a lower level of income potential. An investor in the moderate risk range will have a higher tolerance for risk and/or a longer time horizon than more conservative investors. The main objective of this investor is to achieve steady growth while limiting fluctuation to less than that of the overall stock markets.
Moderate aggressive This allocation is designed for investors with a relatively high tolerance for risk and a longer time horizon. These investors have little need for current income and seek above-average growth from the investable assets. The main objective of this profile is capital appreciation, and its investors should be able to tolerate moderate fluctuations in their portfolio values.
Aggressive This allocation may be appropriate for investors who have both a high tolerance for risk and a long investment time horizon. The main objective of this profile is to provide high growth, which means the investor is not as concerned with receiving current income. This portfolio may have larger and more frequent fluctuations from year to year, making it potentially less desirable for investors who do not have both a high tolerance for risk and an extended investment horizon.
If you’re unsure which category you fall into, take this handy quiz that will point you in the right direction.

Three strategies for managing risk

Before you can manage risk, you need to figure out how much risk is right for you. In addition, you should consider how well you manage your emotions and portfolio when the markets change.

Know your risk tolerance

A risk profile places you on a scale somewhere between conservative (more averse to risk) and aggressive (more tolerant of risk). Your profile can help you select investments and build a portfolio at a level of risk you’re comfortable with, while continuing to work towards your goals.

As your investment goal gets closer, you have less time to recover from short-term market drops. Preserving the value of your investments becomes more important than seeking returns, so your risk profile will probably get more conservative over time since you have less time to invest and recover from downturns.

Don’t buy high and sell low

One of the most efficient risk-management strategies is simply sticking to your plan. By choosing to stay put, you are giving yourself time to ride out periods of volatility and bear market cycles. When investing for a long-term goal like retirement, the earlier you invest the more risk you may be comfortable with—time helps you recover from market downturns and allows you to take advantage of potential market growth. If you are not very comfortable with risk, starting to invest early can also give you time to grow your account with less risky investments.

Diversify your investments

Your last strategy in managing risk is diversification. Diversification is an important concept to remember when you are building a portfolio. By spreading your money between different investments, you are balancing the volatility of riskier options with the consistency of less risky investments.

Investing can involve risk—but that shouldn’t scare you. In fact, once you understand your risk tolerance and the strategies available to manage risk, you’ll be able to build an investment strategy that helps you feel confident.

These are the most common asset classes for investors:

  • Fixed income. This class includes investments like bonds and Sukuk that provide consistent returns. They involve lower risk but can deliver potentially lower returns than equities.
  • Equity. This refers to stocks. It represents shares of ownership in specific companies. Equities involve higher risk but can deliver potentially higher returns than fixed income investments.
  • Money Market. This refers to cash that customers invest in unit trust funds or money market account open at banks. Money Markets are low risk in nature and provides return rates depending on the bank’s overnight policy rate (OPR). Investing in the money market is relatively better than leaving money idle in a savings account.
  • Cash/others. This refers to any money that you hold. This can include money that you have in your bank account, or money that is invested in cash equivalents, like fixed deposit accounts. This is the least risky asset class.

Avoiding putting all your hopes and dreams into a single asset class is an important aspect of managing risk.

There is also the option of using the dollar cost averaging (DCA) approach to investing, which is a strategy designed to counteract investment risks by investing the same amount of money each month – regardless of market conditions. This averages out the potential spikes and dips and gives you more stable returns.

Read more about the DCA strategy here.

Figure out your risk tolerance with Principal Asset Management

The best way to manage investment risk is to first understand your tolerance and profile. How much can you afford to lose, what are your goals, and how long do you have to reach them?

You could figure things out on your own, but it’s much simpler if someone can lead you in the correct direction. Principal Asset Management is a multi-award-winning financial firm with a team of financial experts.

Whether you’re new to the job market and would like to start investing or if you’ve been in the game for decades and want a fresh perspective on your portfolio, there is something for everyone at Principal.

No investment is without risk; it’s a matter of managing the risks to reach your investment goals. Visit the Principal Asset Management website to learn more and get started on creating your new resilient portfolio.





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