BY FAZAAD BACCHUS
Every day we take risks…. And as it stands there are four ways to deal with risk, you can Avoid it, you can Retain it, you can Transfer it, or you can Reduce it.
First let’s examine two components of risk: Pure and Speculative.
Pure risk involves the potential of financial loss; it means that it’s possible to have a potential loss. On the other hand Speculative risk is one that involves the possibility of financial loss as well as the potential financial gain.
Investments follow a somewhat Speculation model; you never know for sure what the outcome will be.
It doesn’t matter what you invest in, there are pitfalls to every investment, whether you invest in stocks, bonds, mutual funds or real estate you can lose as well as you can gain. The idea is to reduce your risk by understanding how risk works and what type of risk you are exposed to.
Risk is further divided into Systematic and Unsystematic:
Systematic affects the entire market not only one sector or industry and can be brought about by varying factors such as inflation, political changes, tax risks, new trends and changing demographics. Unsystematic risk on the other hand is one that affects the particular investment or is linked directly to the investment only such as business risk, default risk and liquidity risk.
Let’s examine a few in more detail:
Inflation risk is probably one that faces us daily and that which we can do nothing about as the effects of demand and supply control that arena. We see prices going up especially in the supermarket, but as long as we continue to buy, as long as there is demand, there is no need for downward price adjustments. I am sure that by now we have realized that $100 does not buy the same basket of goods as it used to three years ago.
Tax Risk: Governments have the authority to change laws or implement new ones in relation to tax; therefore you can be taxed higher on your earnings or your appreciation of your capital. As you noticed recently the positive change we experienced in the TFSA limit could have seen a reduction in the amount allowable.
Political Risk: What if your investment is in a foreign holding and there are political changes or turmoil in that country, your investment value becomes quite unstable especially if you are unable to liquidate your investment. This leaves you to wonder how much of your mutual fund investment is on a global scale and what are the likelihood of great returns if those countries were to become unstable.
Business Risk: This is an unsystematic risk and is linked specifically to the company in which you have invested. Some investors choose to dump all of their monies into a particular stock of a company and wait for the best; if it goes up they are overjoyed but if it doesn’t then there is a significant loss. The key to steering away from this is through proper diversification.
Default risk: Often times a company defaults on its payment to bond or shareholders especially in the case of mismanagement. While you cannot control the operations of the company you would be better off investing in companies with high credit rating and also diversifying.
Liquidity risk: is the ability to sell an investment quickly. When an investment is difficult to liquidate it may cost you more in fees or commissions e.g. Real Estate. When you need to convert your asset into cash quickly liquidity risk becomes quite important.
The final word is that we must invest, regardless of the goal or investment type, but to have the best chances of a good return given our risk tolerance, its best to use the services of a qualified financial advisor.
