More about risk
Return, timing and risk: those are the three key facts we must be aware of before we even think about investing. What do we expect to get; when do we expect to get it; and how sure can we be of getting what we expect and when? It’s this last question that we will be talking about here and on the next couple of pages.
What do we mean by risk?
When we talk about risk, we are really referring to two independent issues. The first is that there is a probability, however small, that a damaging event will occur. The second is that we could be affected by it. For example, skiing accidents are only a risk to people on the ski slopes and their families or dependents. Suppose you work for a large public company, the shares of which are listed on a stock market. As long as you don’t own any shares, you are not affected by what happens to share prices. Markets rise, markets fall. As long as the effects of market falls don’t damage the trade of the company, there is no risk to your standard of living. If you own your own home and never intend to sell it, house prices are not a risk to you.
All investments are risky but not investing is risky too
There is no such thing as a risk-free investment. Economists do refer to a ‘risk-free rate’, which usually means the rate of return on Government Bonds. However even Index Linked bonds, which can protect you against inflation, don’t have any link to economic growth. Economic growth eats away at our spending power in the same way as inflation because it makes other people richer and real assets more expensive. The longer our investment horizon the more concerned we need to be about the effects of inflation and growth. We could argue that inflation and growth aren't a risk because they are a certainty, but what we don’t know is how much growth and how much inflation. We can be sure that they will change the real value of money but we can’t be sure by how much, and that’s a risk we all have to face whether we invest or not.
Other risks to investment
Leaving aside the problems of inflation and growth, let’s think about what else can go wrong when we save or invest. What we want to know is how sure we can be of getting the returns we expect, when we expect them. We talked about returns coming in three flavours: lump sum; income stream; income plus lump sum. Most of the investments we are likely to be involved in are market-based to some extent. Even redeemable financial assets can usually be sold through securities markets if we decide that we don’t want to hang on to them until maturity. Investments that deliver some or all of the return in a lump sum are therefore exposed to market-risk. Investments that deliver some or all of the return as income are exposed to other risks. When we are dealing with money in any form, we are exposed to the risk that whoever we trust with our money might cheat us or go bust.
We need to recognise that all these risks are different, and we will look at each of them over the next two pages.
|9 October, 2008 © 2008 K.R.Wade and Co Ltd|