Investing: Ignore Emotional Risks, Focus On Fundamentals

When it comes to investing, it's important to understand the risks involved and make informed decisions. While all investments carry some level of risk, not all risks are created equal. The main risk is losing money, either partially or entirely, and not achieving the expected returns. This could happen due to various factors, such as market unpredictability, company performance, or economic issues. To make smart investment choices, individuals should evaluate their risk tolerance, which is influenced by factors like investment objectives, time horizon, reliance on invested funds, and inherent personality traits. Diversification is a crucial strategy for managing risk, where investors spread their investments across a range of assets to balance potential losses. It's also essential to remember that risk and return are linked; historically, lower-risk investments tend to yield lower returns, while higher-risk investments offer higher potential returns.

Inflation risk

Inflation is an overall increase in the cost of living, which leads to a decrease in purchasing power. As inflation occurs, money buys less over time. For example, if you have a return of 5% in your stock portfolio but inflation is at 6%, the real return is negative (-1%).

To protect against inflation risk, investors can build an inflation premium into the interest rate or required rate of return (RoR) demanded for an investment. For example, if a lender expects the value of money to decline by 3% in a year, they can add 3% to the interest rate they charge to compensate.

Some securities also provide protection against inflation risk, such as Treasury Inflation-Protected Securities (TIPS), which adjust their coupon and principal payments according to changes in the consumer price index (CPI).

Risk tolerance

• Investment Objectives: The level of risk an individual is willing to take depends on their investment objectives. If an individual seeks significant growth, they must also be prepared for the possibility of significant losses. On the other hand, if capital preservation is the main objective, they might choose lower-risk investments, which might not yield the desired income or growth.
• Investment Time Horizon: An individual's risk tolerance is also influenced by their investment time horizon. If they are planning for the long term, such as retirement, they can generally afford to take on more risk as they have more time to recover from potential losses. Conversely, if the investment timeline is short, they would likely want to avoid significant risks as they approach their withdrawal date.
• Reliance Upon Invested Funds: Another factor to consider is the individual's reliance on the invested funds. If the funds are meant for essential expenses, such as a home down payment or a child's education, the investor might be more cautious. In contrast, if the funds are disposable income, they might be more open to taking on higher risks.
• Personality: An individual's inherent personality traits play a role in their risk tolerance. If they are generally cautious and risk-averse, they might prefer safer investments. On the other hand, if they are more adventurous and comfortable with volatility, they might be willing to take on higher-risk investments.
• Income and Financial Stability: A steady and stable income stream can provide a safety net, allowing individuals to invest in higher-risk, higher-reward assets. Additionally, financial stability enables diversification across different asset classes, reducing the impact of any single investment's poor performance.
• Life Circumstances and Personal Goals: Life events such as marriage or starting a family can shift an individual's focus towards financial security and stability, leading them to favour more conservative investments. Conversely, a financial windfall or inheritance might increase their willingness to take on more risk.
• Investment Experience: Seasoned investors are typically more comfortable with market volatility and complex investment products. On the other hand, those new to investing might have a lower risk tolerance due to their lack of familiarity with the market.
• Psychological Factors: An individual's psychological makeup, including behavioural biases such as overconfidence, loss aversion, and anchoring, can significantly influence their risk tolerance. Understanding these factors is crucial for aligning investment decisions with their personal comfort levels.
• Economic and Market Conditions: Market conditions can also impact an individual's risk tolerance. In a bull market, characterised by rising stock prices and economic optimism, investors might be more inclined to take on higher-risk investments. Conversely, during bear markets, risk tolerance might decrease as prices fall and market sentiment becomes pessimistic.

It is important to note that risk tolerance is not static; it can evolve over time as an individual's financial circumstances, investment experience, and personal preferences change. Therefore, regularly reassessing risk tolerance and adjusting investment strategies accordingly is essential for maintaining a balanced and effective portfolio.

Risk capacity

The time horizon refers to the length of time an investor plans to stay invested, and it is a key factor in determining risk capacity. Generally, a longer time horizon equates to a higher risk capacity. Younger investors, for instance, tend to have a higher risk capacity because their money can remain in the market for longer, allowing for potential recovery from market downturns.

The second factor, the size of the investment portfolio, considers the balance between the current value of the portfolio and the potential for future additions and withdrawals. If the future additions bucket is significantly larger than the current portfolio bucket, there is a greater capacity to accept investment risks.

Lastly, the amount and reliability of income from sources outside the investment portfolio play a crucial role in risk capacity. A steady and growing source of income can provide a safety net that enables investors to take on more risk.

It is important to note that risk capacity is not static and can change over time as an investor's circumstances evolve. Regularly reviewing one's risk capacity is essential to making informed investment decisions.

While risk capacity focuses on the objective factors influencing an investor's ability to take on risk, it is just one aspect of understanding overall risk. Risk tolerance, which takes into account emotional responses and comfort levels, is also crucial in shaping investment strategies. Together, risk capacity and risk tolerance help investors determine the right balance of risk and return to align with their financial goals.

Risk-return trade-off

Each investor must assess their risk tolerance and decide how much risk they are willing and able to accept for their desired returns. This decision is influenced by various factors, including age, income, investment goals, liquidity needs, time horizon, and personality.

For instance, younger investors with a longer time horizon until retirement might be more inclined to take on higher-risk investments, as they have more time to recover from potential losses. On the other hand, older investors with a shorter time horizon might opt for lower-risk investments to preserve their capital and ensure stable returns.

Additionally, an investor's risk capacity, or the amount of financial risk they can take, is determined by their current financial situation. This includes factors such as income, net worth, and short-term and long-term spending requirements.

It is essential to note that higher-risk investments do not always equate to higher returns. While they offer the possibility of higher returns, there are no guarantees.

When constructing an investment portfolio, investors often utilise the investment risk pyramid as a framework. This pyramid has three tiers:

• The Base of the Pyramid: This tier consists of low-risk investments with foreseeable returns, such as cash and fixed-income assets. It forms the largest portion of the portfolio, supporting the rest of the pyramid.
• Middle Portion: This tier includes moderately risky investments that offer stable returns while allowing for capital appreciation. Examples include corporate bonds and blue-chip stocks.
• Summit: This tier is reserved for high-risk investments and is the smallest area of the pyramid. It comprises money that the investor can afford to lose without serious repercussions.

By understanding the risk-return trade-off and assessing their risk tolerance, investors can make informed decisions about their investment strategies and construct portfolios that align with their financial goals and comfort levels.

Risk management

Understanding Risk

Firstly, it is essential to comprehend the nature of risk in investing. Risk refers to the possibility of losing some or all of an original investment and the chance that the actual returns will differ from the expected outcomes. This uncertainty arises due to various factors, including market volatility, company performance, and economic issues.

Risk Tolerance

Before investing, individuals should evaluate their risk tolerance, which is their capacity to withstand variability in investment returns. This evaluation involves considering factors such as investment objectives, time horizon, reliance on invested funds, and inherent personality traits. For example, younger investors with a longer time horizon before retirement may have a higher risk tolerance, while those closer to retirement may seek more conservative investments to protect their capital.

Diversification

Diversification is a fundamental risk management strategy. By allocating investments across various asset classes, industries, and individual securities, investors can reduce the impact of any single investment loss. Diversification helps to balance risk and return, with lower-risk investments, such as cash and fixed-income assets, at the base of the portfolio pyramid, and higher-risk investments, such as equities, at the top.

Time Horizons

The investment time horizon is another critical factor in risk management. Longer time horizons provide more opportunity to recover from market downturns and tolerate higher-risk investments. Conversely, shorter time horizons may require a more conservative approach to ensure funds are accessible when needed.

Emergency Funds and Debt Management

It is essential to have an emergency fund separate from investments to cover unexpected expenses. Additionally, prioritising paying off high-interest credit card debt can be a safer strategy than investing, as it guarantees a positive return by avoiding interest charges.

Regular Review and Rebalancing

Investors should regularly review their portfolios to ensure they align with their risk tolerance and financial goals. Periodically rebalancing the portfolio helps maintain the desired level of risk and return by adjusting the allocation of assets.

Professional Guidance

Seeking advice from financial professionals can be invaluable. They can provide guidance on risk assessment, investment strategies, and portfolio construction tailored to an individual's risk tolerance and goals.

Suitability of Investments

Different investments carry varying levels of risk and are suitable for investors with different risk tolerances. For example, conservative investors may favour government bonds, money market funds, and certificates of deposit, while aggressive investors may opt for stocks, high-yield bonds, and alternative investments.

In conclusion, effective risk management in investing involves understanding the nature of risk, assessing risk tolerance, diversifying investments, considering time horizons, maintaining emergency funds, regularly reviewing and rebalancing portfolios, seeking professional guidance, and choosing suitable investments based on risk profiles. By implementing these strategies, investors can make more informed decisions and build resilient portfolios that align with their financial goals and risk appetite.

Frequently asked questions