For many people a vital and driving goal – at least monetarily speaking – is the need to be financially secure; to not be beholden to anyone. This is a translation of personal success to financial success of sorts, which sees your balance sheet being able to sustain your lifestyle without you having to earn another paycheck, says John Kennedy, Citadel Director: Wealth Planning and Regional Head: Western Cape.
Achieving this goal is often the culmination of years of concentrated and focused effort. It is characterised by sacrifices, tradeoffs, risk taking and patience, often over decades. This journey applies as equally to entrepreneurs as it does to those who choose to pursue a career in the corporate world, or any other space.
One of the by-products of your success is money and the utility of money comes with a feeling of empowerment, freedom, security and the ability to help those we love and those in need. It means having choices and so much more.
In implementing and executing an investment plan the objective should be to make your capital productive and, in doing so, to ensure it protects you against a range of risks that you may face. Risk is multi-dimensional and not limited to any one metric.
What follows are four risks that that have the ability to cause a permanent loss of capital.
1. INFLATION RISK
One of the key risks to capital is the erosive effect of inflation over time. The monthly quoted statistics commonly known as CPI (Consumer Price Index) or PPI (Producer Price Index) which measure the nominal change in the prices of what we consume or what is produced respectively. Inflation risk, sometimes referred to as purchasing power risk, is the chance that the cash flows from an investment won’t be worth as much in the future because of changes in purchasing power due to inflation.
Although inflation risk may come across as a less worrisome risk, it’s important to understand the power of compounding. Compounding can work wonders in an investors favour, but getting yourself trapped on the wrong side of it can make breaking free from it difficult.
A very simple example of this is at 5% per annum the purchasing power of R1 million is ‘trimmed’ into R598 000 over 10 years, into R358 000 over 20 years and R214 000 over 30 years (all values rounded).
2. VALUATION RISK
Price matters, no matter what one buys. The difficulty, in most situations, is the difference between the price one sees and is quoted, and the value; which is somewhat harder to measure.
Valuation risk is defined as the financial risk that an asset is overvalued and is worth less than expected when it matures or is sold. Factors contributing to valuation risk can include incomplete data sets, market volatility, financial modeling uncertainties and below par data analysis by the people responsible for determining the value of the asset.
This risk can be an issue to flag for investors, lenders, financial regulators and other financially astute stakeholders.
There are a range of methods to determine value, given that overpaying for an income stream (be it for rentals, corporate earnings, fixed income, among others) ultimately sees some form of reversion.
3. CREDIT RISK
Credit risk affects you whenever you hold an asset where you have lent money and the borrower is expecting to use future cash flows to pay back your debt. It more specifically refers to the risk that a borrower will default on any type of debt by failing to make required payments.
One hears and reads extensively about the role of global ratings agencies – Standard and Poor’s, Fitch and Moody’s – in the financial lives of governments and parastatals. They continuously assess the credit risk of these institutions and determine a rating on the risk of loss of principal or loss of a financial reward stemming from any actual or perceived failure to meet their contractual obligations.
A current and larger example of this is Greece’s inability to pay back the outstanding debt the country owes to the European Union (EU). As many have seen, socially driven revolts and riots can stem from large-scale credit risk situations, when left untouched. After receiving EU bailouts worth €240 billion over five years, Greece recently (on 30 June 2015) defaulted on yet another payment to the International Monetary Fund (IMF) to the value of €1.5 billion. With the remaining €10 billion still owed to the IMF, the European Central Bank, the European Investment Bank and various other private investors in 2015, the interest payable on this default will start to snowball.
It’s a very real investment risk in the current environment, as global interest rates are abnormally low. However, as the cycle turns the higher the perceived credit risk becomes for many corporates and institutions which borrow money.
4. LIQUIDITY RISK
While the price of an asset is only freely available, this risk stems from the inability to buy or sell the investment quickly enough to prevent or minimize a loss.
In most cases the risk is on the downside where forced or panic selling takes place given some form of crisis event. A case in point is the aftermath of the 2007-2008 credit crisis where rising liquidity risk became a self-fulfilling prophecy. Liquidity risk may lower the value of certain assets or businesses due to the increase in potential capital loss. Panicking investors were spooked into selling their holdings at any price, causing spreads to widen and large price declines, which further contributed to illiquidity. And the spiral continued.
Your investment strategy should guard you from potential permanent loss of capital; from either overpaying for something, being a victim of inflation, taking on too much credit risk or getting tied up in illiquidity when you least need it.
The formulation of your strategy is commonly known as your asset allocation and the weighting between the assets is driven by absolute and relative considerations. Overlaying the asset allocation would be the risk profile of an individual investor, which would measure his or her ‘appetite’ for risk. Suffice to say the allocation should ensure that you have sufficient productive assets to generate real wealth, sufficient defenses in place to protect you when financial markets act irrationally and enough cash to remain comfortably liquid.
It is safe to say that human behaviour doesn’t change and more often than not our behavioural biases get in the way of successful investing. A crisp and clear investment plan, which sets out one’s objectives and the risks one is managing, should always serve the end investor; be it inflation, valuation, credit or liquidity risk.
John Kennedy, Citadel Director: Wealth Planning and Regional Head: Western Cape