Investment risks – what is your risk tolerance?

Investment risks – what is your risk tolerance?

How much are you willing to stomach massive swings in the value of your money?

There’s a degree of risk attached to every savings and investments.

Saving your money in a bank makes you susceptible to inflation risks. Investments vehicles like stocks, bonds, real estate, mutual funds, farms and exchange-traded funds can lose their value too.

Even conservative investments like treasury bills come with inflation risk too. Sometimes, these low-risk assets do not keep pace with the increasing cost of living in your country.

How not to evaluate an investment opportunity

“Many amateur investors compare their investments solely on the basis of yield. For them, Google shares with a return of 20 per cent must be twice as good as a property that returns 10 per cent. That’s wrong. It would be a lot smarter to also consider both investments’ risks.”

Rolf Dobelli

It’s not just “amateur investors” that have problems assessing risks. We all do.

In his book, “The Art of Thinking Clearly”, Rolf Dobelli says it is against our natural instinct to think clearly about percentages and statistics. Backed up by an experiment conducted by some researchers in 1972 which showed we respond more to the “expected magnitude of an event” rather than the probability or likelihood of the event happening.

Relationship between Risk and Reward

The level of risk of an investment or asset class typically correlates with the returns. The higher the risk, the greater the return on investment.

Much similar to how life works too. You take on more risk – in career or faith – you are likely to get more out of life.

Historically, stocks often perform better over the long term than corporate bonds or treasury bills. But stocks have often been plagued with high volatility (huge rise and fall in prices), which makes it difficult to predict prices at any point in time. In 2008, 46% of investors’ investment was wiped off in the Nigerian stock exchange, while the US financial market fell by more than 30 %.

Also, since cryptocurrencies became a new asset class, they have rewarded investors with higher returns than stocks. But the volatility risk in crypto is higher than stocks too.

In investment, risk and return correlate positively.

Types of investment risks

Some risks you need to consider before making an investment or saving your money in a bank account.

1. Market risks

An unpredictable risk that affects all the asset class in a market.

Example: In 2008 when the Nigerian stock exchange crashed, it was caused by the banking crisis which very few saw coming. The banks had sunk their teeth into debts and needed a bailout from the central bank. The All-share index of the exchange plummeted because of the panic.

2. Business risk

When you invest in a company through share purchase or a farm through a crowdfunding platform, you are literally signing up to partake in any risk that threatens the company’s ability to meet its target or achieve its financial goals.

Some risks businesses are exposed to include: government regulations, competition, change in consumer taste etc. Returns could be affected in the event of an adverse change.

3. Political risk

In countries with underdeveloped political systems, this is a real risk. National elections and political instability could affect investors’ returns.

For instance, in 2018, before Nigeria’s General Elections, the Capital market was mostly bearish as investors were selling off their stock portfolio or adopted a “wait-and-see” approach because of the possibility of electoral violence and tensions

4. Currency/foreign exchange risk

Your investment’s value may decrease due to the devaluation of your country’s currency.

Since December 2008, the Naira has declined by more than 300 % from N116  to N360 in 2019. That has proved destructive to a lot of investment portfolio and people’s savings denominated in Naira.

5. Liquidity risk

Lots of investments in Nigeria suffer from this type of risk, especially real estate, crowdfunding platforms and stocks on the Nigerian stock exchange.

Liquidity risk means an investment can’t be easily bought or sold quickly enough to provide cash flow.

6. Environmental risk

This risk is mostly associated with real estate and agriculture. When a place is bedevilled with violence or there’s often massive flooding, the value of properties in that area suffers devaluation. Also, output on a farm could suffer from the spread of disease.

How to manage investment risks

Research and due diligence

This is the all-important prerequisite to managing risks. Never take any investment offer on its face value: Dig deeper to find out fees; identify the degree of risks associated with the investment/business; and most importantly, who’s the team behind the project? (Can you trust them?)

Hedging

This is necessary to reduce exposure to losses with high-risk assets. You could buy another investment designed to limit the losses of your investment. Experienced investors often buy assets that have zero correlation to offset risks in a vulnerable asset.

Also, taking up an insurance policy on a property or farm is a type of hedging.

Diversification

One of the best ways to reduce the total risk of an investment portfolio while keeping returns high is to diversify your investments across various asset classes. Even within an asset class, you could diversify into different investment products

For example, if you are investing in agriculture, it would be wise to invest in different crops so that a ravaging disease in one particular crop doesn’t lead to the total loss of your portfolio.

Also, to increase the overall returns of your porfolio you should consider high-risk assets like stocks and cryptocurrencies. One per cent of your investment portfolio in crypto could greatly increase your returns.

Dollar-cost Averaging

Instead of investing a lump sum, an investor could build an investment portfolio over time. Especially with stocks and crypto, you could decide to invest a portion of your savings every month. That means you would most likely buy when the market is down and when it is up, and over time your average return could be better than if you had invested a large sum of money at a bad time.

This is often the best approach for an inexperienced investor to invest in assets with high risks and returns.

How to go about investing:

Find out whether you are a “risk-taking” or “risk averse” type of a person, so that you can pursue an aggressive, moderate or conservative investment programme, in other words, an investment strategy that fits your risk profile.

Leave a Comment