Managing investment risks

All investments entail some form of risk. Stocks, bonds, mutual funds and exchange-traded funds can lose value, even all of their value, if market conditions sour. Even conservative, insured investments, such as Fixed Deposit (FDs) issued by a bank, come with inflation risk. They may not earn enough over time to keep pace with the increasing cost of living. There are many risks involved when one invests and it is appropriate to know and understand these.

Risk is any uncertainty with respect to investments that has the potential to negatively affect one's financial welfare. For example, an investor's investment value may rise or fall because of market conditions (market risk). Corporate decisions, such as whether to expand into a new area of business or merge with another company, can affect the value of one's investments (business risk). If someone has invested in another country, events within that country can affect his or her investment (political risk and currency risk).

There are other types of risks as well. How easy or hard it is to cash out of an investment when you need to, is called liquidity risk. Another risk factor is tied to how many or how few investments one holds. Generally speaking, the more financial eggs one has in a basket, for example investing in a single stock, the greater risk one takes (concentration risk).

In short, risk is the possibility that a negative financial outcome that matters to the investor may occur. There are several key concepts an investor needs to understand when it comes to investment risks.

The level of risk associated with a particular investment or asset class typically correlates with the level of return the investment may achieve. The rationale behind this relationship is that investors willing to take on risky investments and potentially lose money should be rewarded for their risk.

In the context of investing, reward is the possibility of higher returns. Historically, stocks have enjoyed the most robust average annual returns over the long term. The trade off is that with this higher return comes greater risk: as an asset class, stocks are riskier than corporate bonds, and corporate bonds are riskier than treasury bonds or bank savings products.

Although stocks have historically provided a higher return, it is not always the case that stocks outperform bonds or that bonds have lower risks than stocks. Both stocks and bonds have risks, and their returns and risk levels can vary depending on the prevailing market and economic conditions and the manner in which they are used.

While historic averages over long periods can guide decision-making about risk, it can be difficult to predict (and impossible to know) whether, given the investor's specific circumstances and with his or her particular goals and needs, the historical averages will play in favour of the investor. Even if he or she holds a broad, diversified portfolio of stocks for an extended period of time, there is no guarantee that they will earn a rate of return equal to the long-term historical average.

The timing of both the purchase and sale of an investment are key determinants of the investment return (along with fees). But while we have all heard the proverb, "buy low and sell high," the reality is that many investors do just the opposite. If one buys a stock when the market is hot and prices are high, he will have greater losses if the price drops for any reason compared with an investor who bought at a lower price. That means the losing investor's average annualised returns will be less than the latter's, and it will take him longer time to recover.

Investors should also understand that holding a portfolio of stocks even for an extended period of time can result in negative returns. In short, if an investor bought at or near the market's peak, he or she may still not see a positive return on the investment. Investors holding individual stocks for an extended period of time also face the risk that the company they have invested in could enter a state of permanent decline or go bankrupt.

Based on historical data, holding a broad portfolio of stocks over an extended period of time significantly reduces an investor's chances of losing the principal. However, the historical data should not mislead investors into thinking that there is no risk in investing in stocks over a long period of time. Investors should also consider how realistic it will be for them to ride out the ups and downs of the market over the long-term.

Then how can an investor manage the risk? Managing risk is an art. Two basic investment strategies can help manage both systemic risk (risk affecting the economy as a whole) and non-systemic risk (risks that affect a small part of the economy, or even a single company). These are:

(A) Asset allocation: By including different asset classes in the portfolio (for example stocks, bonds, real estate and cash), the investor can increase the probability that some investments will provide satisfactory returns even if others are flat or losing value. As such, the investor can reduce the risk of major losses that can result from over-emphasising a single asset class, however resilient the investor might expect that class to be.

(B) Diversification of portfolio: When an investor diversifies, he divides the money that he has allocated to a particular asset class, such as stocks, among various categories of investments that belong to that asset class. Diversification, with its emphasis on variety, allows the investor to spread all his assets around. In short, the investor does not put all his investment eggs in one basket.

The bottom line is that all investments carry some degree of risk. By better understanding the nature of risk and taking steps to manage those risks, an investor places himself in a better position to meet his financial goals.

Anwar Faruq Talukder is a banker.

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