Types of Risk

Investment risk falls into a number of categories. But bear in mind that any one investment can be subject to more than one type of risk.

Inflation Risk
Inflation risk refers to the loss of value in your investment caused by increasing depreciation of the currency. A constant rate of inflation, even if is high, is not risky. When you purchase a long-term bond, for instance, the price of the bond, and therefore its yield, already reflects the current inflation rate.
Rather, it is a rise in the inflation rate that is the source of risk. For example, you buy a long-term bond when inflation is low. If the inflation rate rises, both your bond’s resale value and the value of the interest you receive will decline. After all, the same Ghana Cedi or Dollar is worth less when inflation is high than when it is low.

Deflation Risk
Deflation risk is, not surprisingly, just the opposite of inflation risk. It is the risk that the value of our asset will decline when general prices levels fall during periods of severe recession or depression. Land that you buy during boom times, for instance, may lose value during a serious recession.

Business Risk
Business risk refers to the chance that some event might occur that reduces or destroys a particular investment’s return. For example, you might buy stock in a company that has perfected a pill to cure the common cold. Than a competitor develops a vaccine that prevents cold entirely. Your company’s product becomes obsolete.
Business risk can be more widespread – and more difficult to control. For example, changes in government policy, war, or erratic weather could suddenly wipe out the profits of the cruise ship company whose stock you just bought.

Interest Rate Risk
Interest rate risk is the decline in market value that occurs when the interest rate on new, similar investments rises. For example, you buy a five-year corporate bond paying 8 percent interest. The next year rates rise, and the same five-year bond fetches 10 percent interest. The value of your bond declines.

Market Risk
Market risks refer to the chance that an entire financial market may suffer a decline. Say you buy stock or shares in a prosperous company, but the entire stock market falls sharply in value as it did this year (2009) in Ghana, the US, UK and across the world. Your company is still doing well, but investors are wary of stocks and shares in general, so the price of stock or shares you bought drops.

Illiquidity risk
Illiquidity risk refers to the loss you might have if you’re forced to sell an investment before you had panned. Perhaps you have an unexpected medical expense and much sell some real estates in a hurry to raise the cash. You’ll have to take what the market will give you for your property, because you can’t wait for a better price.

The question, now that you know what the different risks are, is what you can do about them. The answer, in a word: diversify! – Diversification will be the focus on my next post

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Risk and Return & Forms of Returns

Risk and Return
Risk and Return is one of the fundamental concepts under Asset Allocation. The higher the return you expect you expect on an investment, the higher the risk you much be prepared to take. It is an inescapable investment axiom and truth, as the Tables below illustrates:

ASSET...................................................................AVERAGE RETURNS
Ghana stock exchange...................................................................35.2%
Ghana government treasury bills ...................................................2.79%
Bank savings account .....................................................................6.4%
Source: Ghana Stock Exchange, Ministry of Finance and Economic Planning, Ghana and Bank of Ghana – 2008

ASSET...................................................................AVERAGE RETURNS
US Small-Company Stock............................................................ 13.5%
US government treasury bills .........................................................4.3%
Bank savings account .....................................................................6.4%
Source: www.financialsense.com, www.capitalone.com

Of course, greater risk does not guarantee greater return. If it did, you would always choose high-risk investment. ''After all', you might say, ' the higher-return investment carry more risk, but I'm certain to be well reward – just look at the tables.'

The returns shown on the tables, though, are average returns of assets in those categories. The tables really illustrates the fact that, as the expected average return from an investment rises, the range of possible returns also expands

Now that we have seen how risk and return relate to one another, let's us look at the different kinds of returns.

Forms of Returns
You can expect two types of return from any investment: current income and appreciation.
Current income is the amount of cash an investment generates on a regular basis. Various kinds of investments provide current income. so-called dept instruments – Treasury bills, savings accounts, bonds and similar investments, in which you're really loaning money to the government or to a financial institution – pay interest at regular intervals. This is current income.
Stocks generate current income in the form of dividends. And real-estate investments can produce current income in the form of rent.

Appreciation, on the other hand refers to the increase in the price of an investment from the time you buy it until you sell it. Of course the price doesn't have to rise; it can fall as well. This unfortunate event is known as depreciation (not to be confused with depreciation as the word is used in accounting and taxes).
An investment's from of return – current income and appreciation (or depreciation) – is, as we shall now see, closely related to its degree of risk.

The Relationship of the Form of Return to Risk
Generally, the more an investment depends on current income to generate a return- and the less it depends on appreciation – the less risky it is. In other words, betting on future growth is riskier than collecting dividends and interest as you go.

The reason: you know an investment that pays current income will usually return at the very least, a specific sum at regular interval (barring unforeseen circumstances of course)
So a dividend-paying blue-chip stock is less risky than a non dividend –paying growth stock. A certificate of deposit carries less risk than a zero-coupon corporate bond.

But what, exactly, do we mean by risk? In fact, there are several different kinds of risks and that will be the focus on my next series of posts

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Constructing Your Financial Profile – Your Tolerance for Risk

So far we have discussed Your Stage of Life and Your Life-Style the first two of five steps in building your financial profile. Your Tolerance for Risk is the third step in this process.

You must ask yourself tow questions when it comes to assessing your tolerance for risk: Do you HAVE any money to risk? If you do, what promised rate of return would it take for you to risk it? The first is a question of resources; the second a question of attitude.

To some extent, of course, it really doesn’t matter if you’re the type to stake all on a spin of wheel – or inclined to tuck your money under the mattress. What is vital though is accurately assessing how much you can afford to loose – the resource side of the risk coin.

If you can afford to lose all or part of the amount you invest without undue hardship, the odds that your investment will pay off are vitally important.

If you can’t afford to lose your investment, the odds are irrelevant, because you can’t make the investment no matter how great the potential payoff.

Let’s say you have the opportunity to invest GHc1,000 (or $1,000). And you stand a chance of making GHc10,000 (or $10,000) or losing the entire amount you invested. You go ahead with the deal. You like the possibility of earning a 1000% returns on your investment and you can afford to lose your GHc1,000 (or $1,000) stake.

But suppose the same opportunity required a minimum investment of GHc100,000 (or $100,000).And you could make GHc1million (or $1million) or lose your entire investment. Although the odds are identical (i.e. 1000% interest rate) and you would like the chance to earn GHc1million (or $1million), you let the opportunity pass. Why, the reason is simply: You can’t afford to loss the GHc100, 000 (or $100,000).

Once you analyze your resources and figure out what you can afford to lose, your attitude comes into play. And be advised: if you think you are a risk taker, you could be in for a surprise.

Researchers have found that the risks people take with their money differ from the chances they take in other areas of their lives. There are skydiving enthusiasts, who invest sorely in well established and reliable shares and kindergarten teachers who regularly trade in shares of newly established companies with no magnificent history.

Some risk takers who say they wouldn’t hesitate to put money into a new business that could fail – as long as the possible return was high are the same people who steer clear of investing in ‘safe’ shares – those with steady returns but little potential for appreciation.

Here are a few differences between high-risk takers and the risk averse:

Risk takers are better money managers.

Risk takers spend more time reading about money and investments.

Risk takers have confidence in their money-making schemes.

Risk takers have leadership abilities

Risk takers are good sales people.

Its been proven that when it comes to risk taking, stereotypes don’t hold water. Women, for instance are no more risk averse than men

But people are less likely to take risks with their money as they grow older. The simple reason: Their fear of loss is greater than their hope of gain. In other words, it is not the returns on the money that matters but the return OF the money.

Like Life-style choices, there are no absolute rights and wrongs when it comes to attitudes about risk. The important point to remember: Know your own tolerance and make financial decisions accordingly.

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Investing 101: Knowing Yourself - Part 4

Success depends on ensuring that your investment strategy fits your personal characteristics.Even though all investors are trying to make money, each one comes from a diverse background and has different needs. It follows that specific investing vehicles and methods are suitable for certain types of investors. Although there are many factors that determine which path is optimal for an investor, i'll look at three main categories: investment objectives, and investing personality.

Investment Objectives Generally speaking, investors have a few factors to consider when looking for the right place to park their money. Safety of capital, current income and capital appreciation are factors that should influence an investment decision and will depend on a person's age, stage/position in life and personal circumstances. A 75-year-old widow living off of her retirement portfolio is far more interested in preserving the value of investments than a 30-year-old business executive would be.

Because the widow needs income from her investments to survive, she cannot risk losing her investment. The young executive, on the other hand, has time on his or her side. As investment income isn't currently paying the bills, the executive can afford to be more aggressive in his or her investing strategies. An investor's financial position will also affect his or her objectives.

A multi-millionaire is obviously going to have much different goals than a newly married couple just starting out. For example, the millionaire, in an effort to increase his profit for the year, might have no problem putting down $100,000 in a speculative real estate investment. To him, a hundred grand is a small percentage of his overall worth. Meanwhile, the couple is concentrating on saving up for a family car and can't afford to risk losing their money in a speculative venture. Regardless of the potential returns of a risky investment, speculation is just not appropriate for the young couple. As a general rule, the shorter your time horizon, the more conservative you should be.

For instance, if you are investing primarily for retirement and you are still in your 20s, you still have plenty of time to make up for any losses you might incur along the way. At the same time, if you start when you are young, you don't have to put huge chunks of your paycheck away every month because you have the power of compounding on your side. On the other hand, if you are about to retire, it is very important that you either safeguard or increase the money you have accumulated. Because you will soon be accessing your investments, you don't want to expose all of your money to volatility - you don't want to risk losing your investment money in a market slump right before you need to start accessing your assets.

Personality
What's your style? Do you love fast cars, extreme sports and the thrill of a risk? Or do you prefer reading in your hammock while enjoying the calmness, stability and safety of your backyard? Peter Lynch, one of the greatest investors of all time, has said that the "key organ for investing is the stomach, not the brain". In other words, you need to know how much volatility you can stand to see in your investments. Figuring this out for yourself is far from an exact science; but there is some truth to an old investing maxim: you've taken on too much risk when you can't sleep at night because you are worrying about your investments.

Another personality trait that will determine your investing path is your desire to research investments. Some people love nothing more than digging into financial statements and crunching numbers. To others, the terms balance sheet, income statement and stock analysis sound like a Ghanaian trying to read Greek. Others just might not have the time to plow through prospectuses and financial statements.

Putting It All Together: Your Risk Tolerance
By now it is probably clear to you that the main thing determining what works best for an investor is his or her capacity to take on risk. I've mentioned some core factors that determine risk tolerance, but remember that every individual's situation is different and that what I've mentioned is far from a comprehensive list of the ways in which investors differ from one another.

The important point of this section is that an investment is not the same to all people. Keep this at the back of your mind for upcoming sections of this tutorial.



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