Risks Involved in Investing

Every investment has risk and dealing with risk is a normal part of investing.  It's important you understand the risk each investment has so you can make informed decisions. 

Is it worth the gamble?

Risk is the chance an investment won't give you the outcomes you want. For example, you expect your investment to grow but its value falls. Or you expect regular interest of 4% but interest payments fall to say 2%. Or you expect to be able to get your money whenever you need it but your managed fund suddenly freezes withdrawals.

Authorised Financial Advisers (AFAs) and Qualified Financial Entity (QFE) Advisers, for example bank staff, can help explain the risks involved with investments.  AFA's have met minimum qualifications and professional standards.  They can advise on complex products and can also offer investment management and planning services.  QFE Advisers can advise on investment products such as KiwiSaver or managed funds but only on the products provided by their company. Spending a bit of time early on with either an AFA or QFE Adviser could save costly mistakes and money in the long term.

It's impossible to avoid all risks when you invest. Higher potential returns usually come with higher risks. The important thing is to understand the risks and then keep within a level you are comfortable with.

Understanding risk

Successful investors understand the main types of risk that can hit their investments. If you do, you will have a much better chance of avoiding the 'ouch' factor from taking too many risks.

The specific risks to keep an eye on depend on your needs and the type of investments you make. 

Short-term savers

If you want to spend your money within 3 years, your main concern will be to protect your capital. A high interest savings account, with a registered deposit-taking institution, carries minimal risk and your money will be available when you need it.

The short-term saving case study looks at how to manage these risks. 

Long-term investors

If you're investing for the long term, say more than 10 years, you want your capital to grow in value. Risks you face include:

  • Inflation may erode the purchasing power of your money (this means that a fixed amount of money will buy fewer things in the future).
  • The timing of your decisions may cause lower returns or loss of capital (buying at a market peak, selling when the market is down).

The capital growth case study gives examples of how to deal with such risks.

Retirees

As a retiree you rely on your investments to give you money to live on. You need them to give you regular, reliable income payments. The risks you face include:

  • Your investments will not produce a regular, consistent income. For example, share dividends are usually only paid twice a year and are not always paid out. Interest rates can go down, reducing your income.
  • Inflation may erode the purchasing power of your money.

The regular income case study tells one retiree's investing story.

Check Sorted's website for more information about planning for retirement and retirement income.

 

Common risks to be aware of

There are other types of risk that can hurt your investments if not managed properly. Interest rate changes, currency movements and changes in the law can all affect how your investments perform. The types of risk that routinely affect investments include:

  • Interest rate risk: when interest rates rise after you lock in your money, meaning you don't earn as much on your money as you would have if you'd invested at the higher rate
  • Liquidity risk: there might not be buyers interested in your investment when you want to sell
  • Credit risk: the organisation may not be able to repay its debts, and you might lose your money. Find out more how to sort out problems with your investment.
  • Economic risk: the economy may or may not be doing well, which could affect the value of your investment
  • Industry risk: risks affecting a particular industry, like shortages of raw materials or changes in consumer preferences
  • Currency risk: your investment is affected by changes in the value of the New Zealand dollar
  • Inflation risk: your investment doesn't earn enough to keep up with inflation.

Every investment has its own combination of risks and it's important to understand them before you hand over any money. There may be other risks specific to the type of investment or market, in particular, you should always read the 'risks' section of the investment statement, or ask your financial adviser to explain these to you.

Use tactics to manage risk

As a general principle, the lower the risk, the lower the likely rate of return. You'll need to take some investment risk to end up with a healthy return over time.

A good plan meets your goals, protects your capital and maximises returns, without exposing yourself to too much danger.

You can do this by:

  • Choosing investments that match your needs and investment timeframes
  • Sticking with mainstream strategies, investment types and providers
  • Diversifying - you'll kick yourself if you lose half your money by putting it all in one place, e.g. one type of investment or one financial institution. See diversification
  • Having some of your investments in low risk assets (such as interest-bearing deposits) that you can draw money from when markets are performing badly

Watch out for investment scams

There are no shortcuts to investing success. The combination of high returns and low risk does not exist. The golden rule is 'if it sounds too good to be true, it probably is too good to be true'.

Being alert to scams will help you stay safe.  Scammers will go to great lengths to come between you and your money so stay one step ahead by checking our latest warnings, alerts and scams. You can also check the Ministry of Consumer Affairs website for their latest scam information.

Investing is never going to be risk free. With careful planning, you can identify and manage the risks that are most likely to trip you up. Diversification is the best tool you have for overcoming investment risk.

Reproduced and adapted with permission of ASIC.  Source: MoneySmart website www.moneysmart.gov.au 31 August 2012.

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