Understanding the importance of risk to your investment

Usually, we pay a great deal of attention to risk in our personal lives, but often make financial decisions without an appropriate understanding of risks involved. For instance, anytime we want to cross a road don’t we look both ways before we actually do?

In simple terms, risk means uncertainty. Risk is a measure of the chance that an investment will not be as good as you expected it to be. There is also the upside of risk, which means with considerable risk comes the possibility of earning a higher return on your investment.

There are various forms of risk that accrue to an investor which when managed efficiently will prove less problematic to your investment prospects, but with their negligence will not only cost the investor his returns but also his principal invested.

Great artists, investors, and entrepreneurs alike are willing to take risk because they see an opportunity to make great returns.

Risk is a crucial element of the investment process, thus having immense understanding of it is equally as important as finding the right investment vehicle. Investors are always advised to seek the services of a qualified financial adviser who can better examine their risk appetite and make appropriate investment recommendations to suit their investment needs.

Every investment has some potential risks expressed in various forms namely systematic and unsystematic risks.

Systematic risk affects the overall market and cannot be diversified but mitigated only through hedging or using of the right asset allocation strategy. Systematic risk ranges from changes in inflation in a country (inflation risk), interest rate changes (interest rate risk), taxability risk and political and governmental risks. Macroeconomic factors causes the fluctuations of returns attributed to this type of risk.

Inflationary risk  (also known as purchasing power risk) is the chance that the value of an investment will decrease as a result of inflation. Inflation shrinks the purchasing power of the nation’s currency, often caused by a general increase in prices of goods and services. For an investor, inflationary risk will mean the return of your investment may not keep up with inflation in the country.  For example, if you purchased a 91 day treasury bill at a rate of 5 percent, and upon maturity the inflation rate in the country was also running at 11 percent, at this point in real terms you are losing money.

Interest rate risk is the possibility that a fixed-rate of return on investment such as money market instruments, corporate bonds, treasuries and asset backed securities will decline in value as a result of interest rate changes. This is mostly seen with bonds.

Taxability risk may arise when a security issued with tax exempt status could potentially lose that status prior to maturity. Tax laws are subject to change and thus could potentially affect the value of one’s investment.

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Unsystematic risk, also known as diversifiable risk on the other hand ranges from operational risk, business risk, credit risk, financing risk, legal risk and liquidity risks. Proper diversification is key to almost eliminating this type of risk.

Business risk is the measure of risk associated with the specific issuer of the security. Generally speaking, all businesses in the same industry experience similar types of business risk. There is a possibility that the issuer of a stock or bond might go bankrupt or might be unable to honor its interest or principal payments in the case of bonds.

Credit risk refers to the possibility that a particular bond issuer may not be able to meet its expected interest rate and principal payments.

The degree to which you tolerate risk in your financial investments determines the path taken to achieve your financial goals.

KNOW YOUR RISK TOLERANCE

As an investor, knowing your risk tolerance is just as important as knowing your shoe size. Thus, it is always appropriate to go for an investment that fits you well. The investment approach suitable for you will solely be based on your level of risk tolerance and no other factor plays such an important role in choosing your investment approach. Knowing your risk tolerance will reveal to the investor to either go for a conservative portfolio (returns will fall less in bad times) or an aggressive portfolio (returns will go up more in good times and vice versa)

In considering your level of risk tolerance it is important to consider certain factors such as time horizon and willingness to take on a particular risk.

Time horizon is fundamental to the risk and return tradeoff for your portfolio. The longer your investment time horizon, the more short term uncertainty you can expose your portfolio. “How long do you need your money back?” will guide you as an investor to consider whether to invest in stocks, money market securities or other investment options. Stocks are seen as long term investments compared to money market securities which have short term maturities.

Risk lover, risk neutral or risk averse categorizes an investor’s willingness to take on risk. A risk lover is willing to take additional risks while investing even if the investment has relatively low expected returns. A risk-averse investor dislikes risk, and therefore will stay away from adding high-risk investments to their portfolio and in turn will often lose out on higher rates of return. Risk neutral investors on the other hand are indifferent to risk and thus only consider potential gains on the investment.

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Even if you consider yourself to have no risk tolerance whatsoever, the best move is not to simply stick your money in a savings account – inflation alone will erode your purchasing power.

RISK-FREE INVESTMENTS

Many academics argue that there does not exist any such thing as risk-free investment because all financial assets carry inherently some level of risk. Risk-free investments are investments that assures certainty of return on investment due to a supreme amount of confidence in the issuer. They appear in various forms ranging from government issued bonds and treasury bills. The risk of default of these investments are relatively low because they are issued by the government. However, the return on risk-free investments are generally low compared to other instruments on the market making it less profitable sometimes.

Risk is an important component in assessment of the prospects of your investment, negligence of this essential component may seriously impact a person’s investment return and consequently even loss of your principal amount.

CONCLUSION

Never underestimate the risk to your investment, make sure you have all the required information needed before you invest your funds. Take your time and read more about the type of investment you want to undertake before you make a move. Remember that it is your hard earned money and nobody can show more concern about your investment than yourself.

 

 

 

 

ABOUT OMEGA CAPITAL

Omega Capital Limited is an Investment management, private equity and   investment advisory firm. The Company is authorized and regulated by the Securities and Exchange Commission of Ghana.

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Analysts:

Nana Kumapremereh Nketiah (JP)

Moses Osei-Yeboah

Omega Capital Research

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No. 23 Sunyani Avenue

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Phone           +233 302 201538

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Email            info@omegacapital.com.gh

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Disclaimer

Additional information is available upon request. Information has been obtained from sources believed to be reliable but Omega Capital Limited                           (“Omega Capital” or “The Firm”) do not warrant its completeness, accuracy or veracity. The firm is licensed and regulated by the Securities and Exchange Commission of Ghana (SEC). This material is for information purposes only and it is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and estimates herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information.

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