When making investments, there are four key risks – irrespective of an investor’s age – to understand and be aware of which if managed correctly should help you to avoid permanent loss of capital.
Firstly, there is integrity risk which refers to the risk of choosing the wrong partner, or making the wrong investment choice. Placing one’s trust in an unscrupulous player is often a quick route to losing money. The lure of unrealistically high or swift returns can appeal to investors who are swept up in the emotion of greed which can overtake logic.
History is littered with examples of chancers who have taken advantage of the human desire to get rich quickly. It is therefore important to assess the quality of investment partners – institutions or individuals – and their ethical standards. Be careful of the promise of excess returns – there is always significant risk involved.
The second risk to be aware of is inflation risk. Inflation is an absolute number and it compounds over time, erasing purchasing power along the way. If you do not beat inflation in real terms (after taking inflation into account), you are going backwards. In addition, it is important to look at the after-tax return. An interest rate of 7.25% currently might sound appealing, but with inflation creeping up from the current 4.7%, on a real basis, the after-tax return is significantly lower.
Fearing capital loss, investors often remain invested in cash or cash equivalents. This is a sure way to erode the value of the capital over time as inflation eats away at the buying power. For example, let’s assume that inflation is 5%. After five years, the same capital would only be able to afford 77.4% of what one could buy at the beginning, thereby guaranteeing an effective loss. It is important to map out the inflation risk over the long term which, for us, is decades.
The third risk I’d like to consider is credit risk or counterparty risk which occurs when one lends money to another party – this is the risk that the interest or the capital will not be paid. We may think that this applies to companies and smaller entities, but governments and parastatals can also find themselves unable to pay the interest on a bond or even repay the capital. For example, since 2010 Greece has been unable to cover its debt and has required three bailouts by other countries in the past five years. Closer to home, in June this year Edcon asked bondholders to take a haircut on its 475 million euros of company bonds as it struggled to keep afloat.
And finally there is valuation risk. This is the risk that the price you pay does not necessarily reflect the underlying value of the instrument – in other words that you have overpaid for it. Investors need to know and understand the value of what they are purchasing. We often look at discounted cash flows to determine the value over time of the stock that is being acquired. You may think that you are getting a bargain if you buy something on a low p:e ratio or a high yield. However, there could be a very good reason for the low price that should not be ignored.
And the same is true when selling an asset. If you sell it at a discount to its true value, you are locking in a loss.
It’s easy to be persuaded to take on some of these risks, especially when greed or fear gets in the way. When investing, be aware of the various risks that you face. Irrespective of your age, adopting excessive risk can lead to capital loss and financial distress.
John Kennedy, Director: Wealth Planning, Citadel