Risk

Written by Mohammed Zubairu, Financial Advisor

Saturday, 21 February 2009 00:00

It is inevitable that when we start to talk about and consider investments that we begin to think about risk. Prospects or individuals looking for a tip about investments with little to no risk always ask me where to put their money. As I have said to all those before, I say to you now, there is no such thing as a riskless investment. Understanding the different types of risks you face and which ones you can afford to take and actually should take are what financial management is all about. If we define risk as the potential of loss then we understand that there is nothing that is immune to that possibility. As risk avoidance is not possible, risk management should be the objective. The only way you avoid risk completely is to not have any assets at all. I am sure none of us want to be in this position, therefore, let us discuss the different types of risk and how to address and manage them.

There are many risks that threaten your financial well being, some obvious, others, not so much. Principal, Interest, Market, Inflation are perhaps the most important risks you should be concerned with.

Principal Risk is the risk that you face of losing your initial investment. This risk is often associated with stock investments; however it is not limited to just stocks. As a matter of fact any investment can be subject to loss of principal, for the loss of principal is simply not getting your entire investment back. If you were to invest in a CD and you were to lose some of the principal because of early penalty, then here too you would have been subject to sum loss of principal. When you invest $100 and only get back $95 there is a principal loss of five dollars.

Interest Risk is the risk that the rate of interest that your money needs to earn will decline below the rate you need for the needs that you have articulated. If you have calculated that you need a rate of 5% during retirement in order to live comfortably, based on the amount of money you have saved, if rates drop to 3% then your principal can no longer help meet your retirement needs. At this point you will then have two choices, you can either begin to spend your principal, or you can cut back on your expenses.

Market Risk is the risk that the market, which is really anyone willing to buy your investment, may not be willing to pay the amount you desire when you want to sell it. This is easiest seen in a stock investment’s decline in price. If you bought a stock two years ago and need to liquidate it today, the odds are that the market price is lower than what you paid. In the same way, if you purchased a house in the same period, it is also likely that the sales price has declined. Therefore, both the markets for stocks and real estate have not gone in your favor in these examples.

Inflation Risk is the risk that your investment will not grow at an equal or greater rate than the prices of the things you need or wish to purchase. If we assume that the rate of inflation for a given period is 3% and your rate of return is 8%, your pre-tax return is 5%. The problem is two-fold: taxes and the fact that inflation is different for different needs. The inflation rate for education and health care is around 8%. This means that after taxes, you could very well be looking at a negative real rate of return even though your account value may be rising. The example here assumes a moderate return; imagine what effect negative returns have on your future plans. It is therefore important to always keep inflation risk in mind.

This discussion about risk is simply to highlight the importance of the different considerations one must have when one is looking at different investments. It is almost impossible to avoid any risk; therefore, it is more important to manage risk rather than attempt to avoid it. What is most important is to get a good understanding of your own personal situation and then establish a plan that addresses your needs.

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