Invest with your head, not your heart: managing investment risk

 

9 April 2020
 

The Coronavirus pandemic is first and foremost a health issue. However, it's also a timely reminder that investment risks always exist. The key to investing wisely is to know the risks you're taking and how your investments are likely to perform within these risk parameters.

 

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The Coronavirus pandemic is first and foremost a health issue. However, it's also a timely reminder that investment risks always exist. The key to investing wisely is to know the risks you are taking and how your investments are likely to perform within these risk parameters.

By better understanding the nature of risk, and taking steps to manage those risks, you put yourself in a better position to meet your financial goals. Good assets and appropriate investment strategies can set investors up for long-term successes, despite market volatility like we’re currently experiencing.

We look at some of the key strategies to managing investment risk.

What is risk?

Risk is the danger that unwanted events may happen or that developments go in an unintended direction. Investment risk is the possibility that you might lose some of your investment, or that the investment may not perform as expected. Generally, the higher the expected returns should be, the higher the chance of a loss occurring and the higher the investment risk. This is known as the risk-return trade-off because if you want the potential for higher long-term returns, you usually need to accept more investment risk.

While people tend to forget about risk when their investments are rising strongly year after year, it feels very real during market corrections—like we’re experiencing now.

When you invest, you’re exposed to different types of risk. Generally, these fall into two broad categories: market risk and company risk.

Market risk Specific risk

These are risks that affect entire markets and impact all investments in a particular market or asset class.

It includes risks that affect economic growth, market sentiment, inflation interest rates, and exchange rates, for example.

Any new law that the Government passes or any new regulatory announcement that affects the value of your investments, for instance, can fall under market risk.

By investing in a range of asset classes and countries, market risk can be largely reduced through diversification.

These are the risks that are inherent in a specific company or industry. It is also called ‘company risk’.

An example of specific risk is the risk of a company declaring bankruptcy, which would negatively affect its share price or the value of its bonds.

By investing in a range of industries and companies, specific risk can be drastically reduced through diversification.

About asset classes

Many investment options are made up of a combination of different asset classes. Understanding their characteristics can help you make informed investment decisions. We define investments in two broad categories: growth assets and defensive assets.

Growth assets are usually shares and property. These investments generally have the potential to earn higher returns but carry higher risk over the short term. The rate of return of the investment may vary and the value of the investment may be more volatile.

Defensive assets on the other hand, generally earn a lower return but also provide less chance of a significant capital loss. These types of assets include cash and fixed income, and returns are less likely to fluctuate in the short term.

Why have any risk in your portfolio?

When you invest, you expect to get a return on your money. You're probably also hoping you'll be able to buy more with your money in the future than you can today. If so, your return needs to be higher than the rate of inflation. As such, the amount of risk and the kind of assets you invest in, can affect your investment outcomes:

  • No risk: you can hold on to defensive assets, such as cash, and eliminate the risk of your dollar value falling but your money may struggle to keep pace with inflation so you may not be able to buy the same goods and services in future that you can buy with those dollars now.
  • Low risk: if you choose a low-risk investment, such as a bank account or government bond when interest rates are low, your returns may not be much higher than the rate of inflation, so you'll probably be standing still financially.
  • Higher risk: if you want your money to grow, you'll need to take on more risk. This means putting some money into growth assets like shares and property. You will usually get higher returns, on average, over the longer term (at least 5 to 10 years), but the trade-off is that they may lose value over shorter periods.

You cannot eliminate investment risk completely, but creating a risk management strategy can help to reduce your risk.

Ways you can manage risk

Every investor should have a risk management framework aligned to their investment objectives and time horizon. There are many things you can and should do to ensure your investments are consistent with your appetite for risk. These include, but of course, are not limited to:

  • Making sure your investment strategy will help you achieve your investment objectives and financial situation.
  • Understanding the nature of the investment you are making and the range of returns you might expect through your investing life.
  • Investing for at least the suggested minimum investment timeframe for an investment.
  • Regularly reviewing your investment considering any changing objectives or financial situation.

As we’ve pointed out, different types of assets classes have different levels of investment risk. Being invested in a range of assets is one of the best ways to help manage investment risk. There are a number of ways you can diversify your investments to help manage your risk:

  • Across asset classes: by including different asset classes in your portfolio (for example shares, fixed income, property, and cash), you increase the probability that some of your investments will provide positive returns, even if others are flat or losing value.
  • Across investment managers: Investment managers have different approaches to buying assets and their holdings will therefore be quite different and will perform differently at any point in time. If you have multiple investment managers with different investment approaches in each asset class you’re adding another level of diversification to your portfolio.
  • Across countries, industries and companies: Shares are an important asset class to help your portfolio grow over the long term and there are lots of shares in Australia and even more all around the world. There are also many different industries you can invest in. And of course, each share you own is your piece of a company and all companies have different factors affecting their returns at any time. That’s why they perform differently and provide another level of diversification.

It’s always important to remember that there’s no guarantee with investment returns. Returns vary and can be positive or negative, so there’s always a risk that the value of your investment may rise or fall at any time. The level of risk that’s right for you depends on factors such as:

  • your investment goals
  • the savings you need to reach these goals
  • your age and the time you have to invest
  • the return you can expect from your investments, and
  • how comfortable you are with investment risk.

Managing risk in the current environment

Given the speed and size of recent share market falls, it’s understandable for investors to feel like there is no light at the end of the tunnel. Optimism is extremely scarce now. However, each of the market tremors of the past four decades—the 1987 crash, the 1997 Asian currency crisis, the 2000 bursting of the tech bubble, and the 2008/09 Global Financial Crisis—eventually ended, and share markets moved forward to recovery.

Unless your circumstances have changed, we encourage you to stay true to your investment strategy. You should carefully consider your individual circumstances before you make any decisions in response to the current situation. We strongly encourage you to speak with your financial adviser, or if you don’t have a financial adviser, please call us on 1300 55 7586 if you wish to discuss your options.

Important information and disclaimer
This article has been prepared by NULIS Nominees (Australia) Limited ABN 80 008 515 633 AFSL 236465 (NULIS) as trustee of the MLC Super Fund ABN 70 732 426 024. The information in this article is current as at 8 April 2020 and may be subject to change. The information in this article is general in nature and does not take into account your objectives, financial situation or needs. You should consider obtaining independent advice before making any financial decisions based on this information. You should not rely on this article to determine your personal tax obligations. Please consult a registered tax agent for this purpose. An investment with NULIS is not a deposit with, or liability of, and is not guaranteed by NAB or other members of the NAB Group. Opinions constitute our judgement at the time of issue. In some cases information has been provided to us by third parties and while that information is believed to be accurate and reliable, its accuracy is not guaranteed in any way. Subject to terms implied by law and which cannot be excluded, neither NULIS nor any member of the NAB Group accept responsibility for any loss or liability incurred by you in respect of any error, omission or misrepresentation in the information in this communication. Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market.