Oran Hall | Let’s talk about risk
There is much talk about risk these days, especially with regard to investments. This is understandable considering the growing interest in investing.
Investors should understand how important it is to make the financial decisions that best suit them and the limitations that may constrain the actions they take.
When the investment community speaks about risk, it is not suggesting that the investor will make a pecuniary loss, but rather that the actual return may vary from the expected return. For example, it may be lower than expected.
It is well established that the higher the risk, the higher the return, but on the flip side, the greater the loss when prices move adversely.
Financial instruments are described as high risk if their prices tend to fluctuate significantly. A good example is ordinary stock. The prices of low- risk instruments tend to fluctuate very little. A good example is money market securities – which mature in one year or less.
The price of longer-term interest-bearing securities – bonds, for example – although not experiencing the sharp price fluctuation seen in equities, do fluctuate. Those that experience the greatest fluctuation are the ones that have a longer term to maturity and have a low coupon rate, the interest rate stated on the instrument. Bonds with a shorter time to maturity and a higher coupon rate fluctuate the least.
The underlying principle is that bond prices move in the opposite direction to interest rates. Thus, when interest rates increase, the prices of fixed rate bonds decrease and vice versa.
Investors who are high risk tend to invest in high-risk instruments and low risk investors are drawn to low-risk instruments. Medium-risk investors occupy a more or less middle position on the continuum.
An investor’s risk profile is also reflected in that person’s portfolio. The portfolio of a high-risk investor will include some low-risk instruments and low-risk investors will have some high-risk instruments in their portfolio. The difference is in the asset mix, which shows the percentage of a portfolio, which is in the various classes of investment instruments.
People give an indication of their risk profile by the type of instruments to which they seem to be naturally attracted. How they react to the likelihood of experiencing loss is also a clue to their risk profile.
People do not all have the same capacity and willingness to take risk. That depends on factors such as age, financial resources, experience, family and other responsibilities, their knowledge of financial markets and instruments, and, importantly, how they are wired.
Some people just seem to be able to take medium to high risk without a bother. Others just do not seem able to do so even if they would want to. Indeed, every investor takes some risk.
If you want to test yourself, here is an idea: select some stocks listed on the Jamaica Stock Exchange to create a notional portfolio. Follow their prices. See how you react to the price movement of the stocks in your “portfolio”.
It is the response to short-term price fluctuations which generally give an indication of a person’s attitude to risk. Generally, over the long term, the short-term fluctuations smooth out and prices thus tend to increase over the long term. This explains why ordinary shares are considered good long-term investment instruments.
It is common for potential investors to complete a questionnaire to determine their risk profile. Investment professionals use this instrument to assist them to advise their clients on how to allocate their funds among the various asset classes when building their portfolio
A good risk profile questionnaire seeks, among other things, information on the person’s age, investment knowledge and experience, time horizon, understanding of the risk, return trade-off, reaction to loss, knowledge of the link between products and investment objective, and expectations.
The person completing the questionnaire may be required to select answers from a set of scenarios, and I am often surprised to see how meagre some of the questionnaires used locally are.
These questionnaires have limitations. They may reflect the biases of the people who design them and sometimes do not gather enough information to make a useful assessment. They tend not to take account of behavioural biases. They tend to generate different results when administered in slightly varying formats to the same person.
The person doing the questionnaire may also limit its usefulness by failing to give accurate information.
Often, investment professionals administer the risk tolerance questionnaire only at the beginning of the relationship with a client. Considering that risk tolerance may change during a person’s life, investment professionals should update the client’s file to keep risk-tolerance information current.
Additionally, investment advisers tend to interpret the result of the questionnaire too literally. The asset mix should be created with ranges stating the minimum and maximum percentage for each asset group, and investors should be protected from taking the maximum allowable loss in any given period.
A risk profile questionnaire is a useful tool, but it is not gospel. It is just a guideline for asset allocation, and low-risk investors should not expect the same level of returns as high-risk investors over the long term.
- Oran A. Hall, author of Understanding Investments and principal author of ‘The Handbook of Personal Financial Planning’, offers personal financial planning advice and email@example.com