Thinking about financial risk

Risk:A possibility, which you invite into your life, that you could lose something important. That something might be your physical safety, a relationship, or something financial.

We are going to talk about financial risk today.

Financial risk is the risk of losing money. This risk can be objective or emotional.

Emotional risk, for example happens when you deposit money at a new bank, somewhere where you have never banked and you don’t know whether they are reliable or not. But they are offering you a higher return and you decide to do that. Only you can decide whether the extra return is worth the extra anxiety.

Emotional and psychological risk also happens when we invest in real-time. If we lose, we become afraid we will lose more. We feel like we want to get out of the market. At this time there is a lot of fear and emotional risk is high. If we gain and market increases in price, we have gained. We want to be in the market because we believe we will gain more. Now emotional risk is low.

However we should understand that when the market is low and emotional risk is high, markets are undervalued and financial risk is low. When markets are high and emotional risk is low, markets are overvalued and financial risk is high.

To counter emotional risk, we need to do either of two things:

  • Have a sound plan, that operates as much as possible on autopilot without you requiring to constantly make decisions
  • Have somebody you trust, a spouse or a financial adviser who will guide you when you are tempted to do the wrong thing.

Objective risk is that which can be described in numbers. What is this for investing?

The broad concept is that you need stocks for growth and bonds for stability. The main question in risk is how much you should have of each. If you get this right, you can easily master risk.

Some things to consider are-

  • Don’t take too much risk by investing too much in stocks
  • Don’t take too little risk by investing too much in cash or bonds
  • Take a moderate approach. 50% stocks, 50% bonds is the baseline. 60% stocks 40% bonds might be okay if you are young and want more returns. 40% stocks, 60% bonds might be okay if you are older and want more stability.
  • Once you are retired and start withdrawing money, you need the volatility to be low. So you will need more bonds than stocks. Many say that the amount of bonds you have in your portfolio should be equal to your age. So if you are 40 years old you should have 40% of your portfolio in bonds.
  • Money you will need within a year should be in cash or short-term bonds. Invest in stocks only if your time frame is 5,10 or 20 years.

Stocks and bonds have their own set of risks.

Risks with bonds:

  1. Default risk: Company or government defaults and does not pay interest
  2. Interest rate risk: Interest rates rise and value of your bonds fall
  3. Reinvestment risk: Interest rates fall and therefore your matured bonds would have to be invested at a lower rate.

Risks with stocks:

  1. Stock risk: Risk of a stock becoming worthless
  2. Stock selection risk: Groups of stocks underperforming
  3. Market risk: The stock market as a whole falling in price
  4. Inflation risk: Not keeping up with inflation( more with bonds)
  5. Asset risk: Being invested in the wrong asset class which under performs over a prolonged period
  6. Tax risk: Decrease in returns because of tax paid
  7. Expense risk: Decrease in returns because of expenses associated with trading.
  8. Event risk: Unknown event topples financial markets
  9. Fraud risk: Somebody cheats you

To counter objective risk, the answer is diversification into various asset classes.

Risk however never ends. It is always there. We have to understand it and deal with it. Some timeless truths can help us do that:

  1. Markets are unpredictable. Nobody can make short-term forecasts.
  2. In the very long run, stock markets trend upwards because of the strength of capitalism
  3. We can see the past clearly and see what we should have done. The future is not that clear.
  4. The market immediate response to good and bad news is exaggerated. Ignore it.
  5. The market rewards perspective and patience.
  6. No investment approach works best every single year.

So to decrease objective risk:

  • Allocate your portfolio into various asset classes.
  • Rebalance periodically
  • Minimize taxes and costs

To assess your emotional risk, ask yourself three questions:

  • Have you lost any sleep over your investments?
  • Do you feel compelled to watch the financial news and check prices daily or weekly? We are talking about feeling compelled and not just curious.
  • Does the financial news make you worried about the future?

If you answered ‘yes’ to any of the above questions, you may have taken more risk. Find somebody who can help you sort the financial and emotional issues that are causing stress in your life.

Ultimately,

Being a successful investor means you have manage risk and manage emotions at least decently. Then you are on the way to success.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s