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Risk Reference Information

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Risk vs Return : what is risk?

All investments contain an element of risk and it is important for investors to have an understanding and awareness of the risks associated with any investment they may hold or that is being recommended. Risk can be defined as the potential for an investment to achieve a return lower than was expected at the time of investing. This ‘unexpected return’ can be due to any number of variables, such as market changes, adverse economic conditions or other specific risks.

Past investment results are not an indication to future performance.

The level of risk that investors are comfortable with varies greatly from person to person. It is critical that any recommendations made are consistent with the level of risk that is acceptable to them.

An investor needs to have a comprehensive understanding of risk to enable them to make informed decisions about their investment portfolios. Risk to some may mean the possibility of losing a portion of their capital, while for others it may mean the possibility that their investment doesn’t generate sufficient income for them to live on.

Risk and uncertainty cannot be eliminated entirely; however they can be measured and managed within your portfolio. The key is to determine the appropriate level of risk for you. Taking on greater uncertainty and short-term risk may be necessary for you to gain the long-term returns needed to achieve your objectives. Any assessment of risk appetite should be in the context of your objectives and the timeframe in which you wish to achieve your objectives.

An integral part of the ongoing management of investment risk is to have your financial adviser review your risk profile and current situation to assist in making investment decisions.

asset classes

The major asset classes of cash, fixed interest, shares (Australian & International) and property all have unique risk characteristics based on the level of price volatility or instability. For example, cash and fixed interest investments are less exposed to market price fluctuations than investments in shares or property and therefore have a lower risk profile. It is important to understand that, in general, the more volatile an investment is, the higher the potential returns from that investment. Conversely, while an investment may have higher potential returns, there is also a higher chance that the investment will fail to deliver an expected return and may decline in value.

Risk (often referred to as Volatility) is a term that refers to the unpredictable upward and downward shifts of investment values over a period of time. The greater the volatility of an investment, the more often its value shifts.

Risk and Return are closely related. In general, the higher the degree of risk associated with an investment, the higher the return required by investors to accept that level of risk. Low risk investments, such as cash, offer relatively low returns as a reflection of their greater security and are better suited to risk-adverse investors. This is called the risk versus return trade-off, and is used as a guide in selecting the appropriate asset allocation for your portfolio.

This relationship between long term (i.e. 7 years or more) risk and return in different asset classes is illustrated in the following graph:

When investing it is important to understand that all investments have associated risks. For example, Government Bonds, which are often described as secure and ‘risk-free’, contain risk for the investor. For example, consider an investor who purchases a 10-year $10,000 government bond, yielding 6.5% per annum (i.e. $650 per annum interest). Next year, the investor finds he needs the funds invested and decides to sell the bond. Since the initial purchase, the yield on the 10-year bond has risen to 9.5% per annum. Under these circumstances, a new investor could now buy a government bond returning $650 per annum for $6,842 instead of $10,000 previously.

This reduces the value of the bond to approximately $8,240, which represents a loss of 17.6% from the so-called ’risk-free’ investment. If the investor was able to wait the full 10-year term of the bond, he would receive the full $10,000 (plus the $650 each year).

Any investment decision you make means taking a risk of some sort. The decision will directly relate to the amount of money you invest, your circumstances at the time and your needs for the future. If you have a better understanding of risk, you can make a more informed investment decision, accepting some risks and rejecting others. The important point is that you understand the relationship between risk and return, particularly over your investment timeframe.

The following is a summary of some of the risks that can affect investors:

type of risk – what it means

1. Mismatch risk: The chosen investment may not be suitable for the investor’s needs, goals and circumstances.
2. Inflation risk: The real purchasing power of the investor’s invested funds may not keep pace with inflation. The real return would then be less than expected.
3. Reinvestment risk: Investors relying on fixed rate investments may have to reinvest maturing money at a materially lower rate of interest if rates generally decline during the life of that fixed rate investment
4. Market risk: Movements in the market mean the value of the investment can go down as well as up – and sometimes suddenly
5. Timing risk: Anticipating market rises and falls can be extremely difficult because no two economic cycles are the same. The strategy of trying to time entry and exit from markets will expose the investor to potentially greater short-term volatility.
6. Risk of not diversifying: If the investor puts all of their capital into one basket a fall in that market will adversely affect all of that capital. An inappropriately large proportion of the investor’s capital would be affected if a single investment does badly.
7. Liquidity risk: The investor may not be able to access their money as quickly as they need to or may be required to pay an additional material amount for the right to achieve that access.
8. Credit risk: Applies to debt-type investments such as term deposits and debentures. The institution you have invested with may not be able to make the required interest payments or repay your funds.

9. Legislative risk: The investment strategies or products could be affected by changes in the current laws and regulations.
10. Gearing risk: If the investor borrows to invest, interest rate changes and margin calls can negatively affect the investor’s ability to retain the investments or the timing of their sale.
11. Value risk: The investor may pay too much for the investment or sell it too cheaply.
12. Manager risk: The personnel or ownership of the fund manager may change so that the manager no longer has access to the skills or attitudes that contributed to earlier performance levels.
13. Currency risk: Investments in assets located in other countries or investments in funds owning underlying investments situated in other countries may rise or fall in value due to the relative value of the Australian Currency to the currency in the country where the investment is located.
14. Refinancing Home: Using the equity in your home to make financial investments Mortgage which can increase and diversify your asset base, but you will be increasing your level of debt and there is a risk that the value of your investment will fall.
15.Too Much Cash Risk: Cash investments do not produce capital growth and you need a lot of cash investments to make a reasonable income from it.
16.Too Much Real Estate: Investing in property can potentially provide rental income, gearing Risk and capital growth. However property is illiquid and requires high level of maintenance and management.
17.Too Many Local Shares: An undiversified portfolio creates risks. You should avoid having Risk a portfolio of only Australian equities and balance your portfolio with cash, international equities and property.

Source: FPA – Appendix 2 – Business Tool 2

Risk and volatility can be managed or minimised in various ways. A particularly risk averse investor may wish to invest only in cash or fixed interest and this may seem appropriate. It must be remembered, however, that a strategy of this type may reduce volatility but is risky in its own right as the investor is foregoing the potential for higher returns in the portfolio.

diversification

The most widely recognised method for managing portfolio risk is through diversification of investments and investment management. To minimise the volatility and risk of your investment portfolio, it is prudent to ensure that it is sufficiently diversified against over-exposure to a single asset, asset class, geographical region or investment manager. This is because no one asset, asset class, geographical region or investment manager provides the best performance over all time periods. A range of investments should reduce the risk of the portfolio experiencing drops in performance across the board simultaneously, as one asset class or manager may perform well to counter the poor performance of another.

Diversification across asset classes

Historically, no single asset class has consistently outperformed all others every year. So by investing across the main asset classes; shares, property, fixed interest and cash, investors may be able to reduce the volatility of their portfolio return. If any investment sector is particularly volatile or performing poorly, other investment sectors may compensate.

A well-diversified investment portfolio would include exposure to the four major asset classes. However, diversification can be further achieved within each asset class. For example, the Australian share market has many sectors, including banking, resources, manufacturing, technology and media. Spreading investments across sectors can reduce the volatility of returns as each industry’s performance will differ, depending upon prevailing market conditions.

Diversification across investment management styles

Investment management styles tend to excel at different times under changing economic and market conditions. Diversification of investment managers lowers the risk profile of your portfolio by providing exposure to different management styles. For example, one manager may have a buy and hold approach whilst another may adopt an active trading strategy. Managers may have preferences for shares with certain characteristics. For example, targeting those that produce franked dividends or those likely to produce capital growth.

Each of these styles can impact your portfolio risk and return. By combining a range of investment managers with complementary investment styles, you are able to reduce the bias to any one style and reduce the impact of any one investment under-performing over a period of time, in comparison to other investments.

Diversification across markets and regions

It is important to spread your exposure within each asset class across a wide range of countries and currencies. This global approach ensures that your investment is not narrowly concentrated in a particular region or industry and helps to reduce the impact of a regional or industry downturn.

There is no right or wrong mix of investments or management styles for a given portfolio. The mix depends entirely on your risk profile and your individual objectives for the portfolio. Some investors may be comfortable with investing entirely in the share market whilst others may seek limited share market exposure.

Before accepting and implementing any investment recommendation, you should be comfortable that the benefits of diversification have been considered and that, where appropriate, a balanced well-diversified portfolio is structured to meet your objectives.