Principle #3 -Understand the Risks

When it comes to making investment decisions many people (including the traineeinvestor) are apt to focus on the potential rewards. To an extent this is only natural - there has to be a belief that an investment will prove to be profitable before we will part with any of our hard earned money. In analysing investments, risks generally get less attention than rewards. This is often a mistake. Professional wealth managers try very hard to produce portfolios that have low volatility (i.e. limited risk).

The old saying that there is no such thing as a free lunch applies as much to investments as it does to other aspects of our lives. One of the most basic rules of the investing universe is that economic rewards can only be achieved by accepting exposure to economic risks. (The relationship is not necessarily a linear one.) Also, the higher the potential rewards the higher the risks which must be accepted to try and achieve those rewards. Even the most secure of investments carry risk. As an example, Treasury bills (often used as a surrogate for the risk free rate of return in financial models) carry risks that are not properly understood. These include:

1. reinvestment risk: the risk that interest rates will drop and it will not be possible to reinvest in securities that will offer the same return;

2. inflation risk: the risk that inflation will erode the real value of your investment;

3. currency risk: if your "neutral" currency is not the US$;

4. opprotunity cost: the cost of not being able to invest the money invested in this investmet in a better investment.

All investments can be analysed in these terms. The next step in the process is to consider the probability of each of the risks occuring and to quantify the extent of the capital at risk should the relevant event transpire. My personal experience is that this is more art than science - maybe smarter people than me can do a better job - but I find that I am often guessing (especially on the probability of occurance question). I do pay very close attention to investments which carry certain risk characteristics:

1. gearing (e.g. leveraged property) ;

2. wasting assets (e.g. options);

3. long lock in periods (e.g. term deposits);

4. high exit or entry fees (e.g. property).

Planning how to respond to certain risks should they eventuate is a key part of any investment decision. Sometimes it can be as simple as setting a stop loss order on a trade when it is entered into. Other investments may require a more sophisticated approach.

A last point about risk is that it needs to be considered in terms of both individual investments and the potfolio as a whole. Professional investors and managers love to include investments which show returns which have low correlation with the general direction of the markets in their portfolios as a means of managing risk.