[WI] What Is Risk?

“Risk” is another very important investment word that is frequently misunderstood.

Unless you know how to calculate the risk in any investment or business you cannot make an informed decision as to whether this will be a good or bad investment for your portfolio.

Early in my investment career I realized that it is impossible to calculate the risk if I take all the risk. If I take all the risk then there is no need to calculate it.

Isn’t this exactly what all investors who are investing in paper assets (like shares, unit trusts, fixed deposits and retirement annuities as examples) do all the time?

They take all the risk.

The financial institution does not accept any risk.

Why do I say that the financial institution does not take the risk?

What happens if the financial institution does not perform according to projections?  Whose problem is it?

Many investors realize this when it is too late to do any thing about it.

The investor will enter in a contract or give a mandate to the financial institution stipulating that the financial institution does not take any risk.

It is the investor’s money and therefore only the investor can loose the money.

This is an arrangement that put the financial institution in the driving seat.

All of this because we accept unconditionally what others tell us what to think and do with our money and we do not want to take responsibility for our own financial well being.

Here is the interesting part.

The investor carries all the risk of the investment but he has no control and cannot manage the risk because the financial institution is in control of the investments on behalf of the investor.

The investor has almost no say in where and how they are going to invest, except perhaps for a mandate as to a specific kind of portfolio to invest in.

The most important factor in financial planning is to determine and manage the risk.

How is it possible that we as investors can be so blind and neglect this in our day-to-day planning?

I believe it is because most investors were raised in an era where they were trained to believe that they do not have a say.

The financial institutions led the investors to believe that there is a module on which the investor can determine their risk profile.

The investor completes a questionnaire and based on the outcome of the questionnaire the investor is instructed as to what kind of portfolio will suit him the best.

I have studied these so-called risk profiles.

It is again my opinion that there is no substance to these except perhaps the fact that it confuses investors to believe that they have a say in managing their risk.

The risk profiles are based on emotion at its best.

I have also seen that investors classified as conservative investors and their money invested in conservative portfolio’s have lost more money then people classified as aggressive investors and visa versa.

Let me give you an indication on how the financial institutions tell us how to determine our risk profiles and how many experts define risk.

Investment Risk.

If you buy shares in a public company and the company goes bankrupt you will loose all you money

If you invest in your own business and the business does not make it you stand a chance to loose everything that you have invested in the business.

You can even take it one step further.

If you stand security you can loose a lot more that what you have actually invested.

Market Risk.

The stock market is based on emotion and sentiment.

You may buy shares in a company that is doing extremely well but because there is a crash in the stock market, the value of your shares may drop.

This has nothing to do with the performance of the company in which you invested.

Lost Opportunity Risk.

Most “experts” will not talk about this risk.

Let me give you an example of how this works.

Lets say you buy shares and the shares drop by 30% over the next month.

Usually the experts will advice you to keep the share and “ride” out the cycle.

If you are lucky and in two years time the market return to the original investment some of the “experts” will tell you that you have not lost anything.

Because you get all your money back.  This for most people is acceptable.

However this is not always the truth.

What will happen if a real good investment opportunity presents itself and because you have kept on to the first investment you have lost the opportunity to invest in the second opportunity because you money was tied up in the first investment?

I have seen this happen in different investment scenarios as well.

Investors will keep a property for example because of the emotional attachment and ignore a far better proposition just because they “love” the location of the property.

Hidden Growth Risk.

No financial institution will tell you about this risk.

Why not?

Because no serious investor will ever invest if they understand this.

The hidden Growth Risk exists because all future maturity values are projected values.

In other words there are no guarantees that it will materialize.

In other words the investor cannot identify, or manage the growth on his investment.

The financial institution has full control over the investment.

The investor signed away his responsibility to manage the investment to someone who will not accept responsibility to manage it.

They take no risk in “managing” your investment and NO REPONSIBILITY TO GIVE YOU A RETURN ON YOUR INVESTMENT, what you get is a promise.

As a full fledge business the financial institution is geared towards making profit – if you win or loose your money is your problem.

That is the way their products are structured.

What about the JSE (Johannesburg Stock Exchange)?

The same principle applies here as well.

The brokers cannot loose.

They receive their transaction fee, no matter what.

In other words not only has the investor the “risk” of loosing his capital investment but he also takes the “risk” of no real growth on his investment even if it may seem as if he is “making” money.

If you earn 10% on your investment but the inflation rate is 15% you are loosing 5% per year on your investment in real terms even if your investment is growing.

The risk then in the growth is that you as an investor have no say on how to manage the growth on your investment.

What is REAL risk?

Real risk is the unknown.

It is the way we deal with the uncertain aspects of investment.

If you cannot identify what can go wrong then you have a risk.

Real risk then starts with ignorance.

The moment that you can identify a risk it is not a risk anymore because you can manage it.

If you cannot identify the risk then the risk will manage you.

If you have no control over the management of the risk then it becomes very difficult to identify the risk.

Sometimes Real risk hides in “confusing” financial terminologies i.e. “market risk, financial risk and lost opportunity risk”.

All of these terminologies “sound” as if you should know what they are but you cannot do anything to prevent these risks.

It is therefore no good if you know what the risk is but you cannot manage it.

The financial institution transfers the risk to the investor no matter what terminology is used.

If an investor understands this principle when he hands over his investment money to the financial institutions then he accepts responsibility for the outcome of the investment.

Let’s look at some of the reasons for the confusion of the investor.

The financial institutions “instruct” the investor as to what risk is and how to manage it.

What is risk tolerance and how does it affect the investor?

The investor is conditioned to think that risk and reward goes hand in hand, the higher the risk the bigger the return and of course also the bigger the chance that the investor can loose everything.

The ideal investment is one that falls within your particular tolerance for risk and has a potential rate of return that exceeds the normal growth for the amount of risk that you as an investor are prepared to take.

When it comes to paper assets this is the truth.

Wealth Creators take notice. 

Now this may seems like good advice to lower your risk but be careful in your thinking, as I will show you shortly why.

There are two different but proven strategies to invest in shares (and unit trusts) to minimize your risk according to financial institutions.

The first one virtually everyone has heard of, but very few investors actually understand how it works.

Rand Cost Averaging.

If you invest R100 every month into a unit trust fund, in the months when the share price is down your R100 will purchase more unit trusts than when the share price is up.

In essence, it means that over a long period of time you will own more units purchased at a lower price than you will own purchased at a higher price.

Thus the average price you paid per share is lower.

If you paid R10 per unit trust share in your first month and ten years later you sell all your units trust for R10 per share, there is a distinct probability that you will still make a profit.

Although the share price changes throughout your ten years of investing the R100 per month the average that you will have paid will be significantly less than R10 per share.

However, if you had taken the money and invested it all at once, and ten years later the share price is exactly the same, then you haven’t made a cent profit.

In fact, you have lost money due to inflation.

You get all your money back, but it isn’t worth as much as when you originally invested it.

The next tried and proven method of investing is more sophisticated and until recently wasn’t even available to the average person.

Modern Portfolio Theory

With the use of this strategy in your investment module you could make the same rate of return but with significantly less risk.

Another way to say it is that you can make a higher rate of return for the same risk.

The Modern Portfolio Theory basically acknowledges that different investments perform differently at times.

So, if you divide your investments between various different investments, when one is down another is likely to be up.

One of the major benefits of this approach is that, in theory with the law of averages, you should have one portion of your portfolio doing well at any given time.

Later in life, when you want to start spending your money, you don’t need to sell the investment that happens to be at a low point at that stage.

You allow the investment to continue through their cycle of recovery and, you will sell those investments that had done very well.

An aspect of good money management that works well with the Modern Portfolio Theory is to regularly evaluate your investment sub- accounts to insure that you always stay invested consistent with your tolerance for risk.

How to calculate your risk profile?

Standard procedure at most financial institutions is to complete a risk profile before investing.

You answer questions like:

• “How would you react if your account dropped more than 10% in one month?” Or,
• “How many years before you will need this money?”

These questionnaires help the financial planner or broker (salesperson) to set up your account from the beginning.

For example, a very conservative investor will probably have a fairly small percentage of his total investment placed into “Small Cap” stocks.

These are small companies with very little working capital and are more risky than companies with Blue chip shares.

When we hit a part of the economic cycle that makes small cap stocks really take off, your portfolio gets out of line with your risk profile because now small cap shares represent a much higher percentage of your total investment.

Modern portfolio management would re-balance your account on a regular basis, like quarterly or semi-annually, by selling off some small cap stocks and buying more of the other investments in your portfolio.

You may have as many as ten or twelve different investment categories:  long-term bonds, short-term bonds, growth, blue chip, small cap, mid-cap, global shares (of foreign corporations), real estate investment shares, commodities and different sector shares such as energy environmental or medical shares etc.

Common investment mistakes.

The single biggest mistake investors in shares make is that they almost always buy and sell based on their emotions.

In other words, they buy out of “Greed” and they sell out of “Fear”.

The stock market usually heats up and investors’ start getting wind of this great thing and it is the desire for the quick buck that motivates them to buy.

When the market makes a major, or in some cases, just a minor negative correction, then everybody panic and sell.

In other words, most investors buy high and sell low and lose money in the process.

Every time someone is buying high someone is selling high, and every time someone is selling low someone is buying low.

Guess who wins?

How can you avoid risk?

It is wise not to invest unless you can calculate the risk potential in the investment.

If you do not know how to identify the risk you will not be able to calculate it.

If you cannot calculate the risk, don’t invest.

It is really that easy, but I know that most people are so conditioned in their believe systems that they will simply not believe a word I am saying.

Here is the truth about paper assets and specifically shares.

You cannot calculate the risk, no matter what any person wants you to believe.

It is impossible to calculate it because you keep all the risk and you cannot manage it.

If you keep the risk and you cannot manage the risk get out, stay out and don’t invest in that asset class or share. It is that easy.

The best way to manage risk is to know what they are.

In knowing the risks you have already eliminate most of the risk.

Risk is the unknowing.

Invest in yourself first; learn how to identify the risk before making a decision.

Don’t get confused by terminology like “rand cost averaging” or the “modern portfolio theory” or “how to calculate your risk profile”.

These are all strategies to confuse you from what the REAL risk is.

The risk of handing over your hard earned money and having no say in the management of the investment.

It is always your responsibility to manage the growth and risk.

It is impossible to manage the risk and growth potential in any investment or business unless you can identify it.

Once you have identified the risk and growth potential of any investment it becomes YOUR RESPONSIBILITY to manage the risk and growth of your investment.

No one else can take that responsibility.

The moment that you give the responsibility away you lose control.

Your responsibility then is to manage the risk to be as little as possible and the growth to the maximum in order to optimize your investment.

How do you manage your risk down and growth up? 

In order to become wealthy your risk must decrease or at least if you can calculate the risk and then apply strategies and techniques to minimize it.

At the same time you must increase the growth potential by applying strategies and techniques.

Unless you can identify both the risk and growth you cannot manage it.

How do you manage growth and risk?

The first step is to identify the risk and growth potential.

Once you have determine the risk and growth potential of your investment you must benchmark it. In other words set the standard from where to improve.

In order to determine what growth you need on your investment you must first determine what surplus you have available for investment.

As you know there are two kinds of surplus and they are of an income or capital kind.

Next you will determine when you want the capital in other words over what period.

Lastly you will have to determine what growth you need in order to achieve your objective.

Let’s say that you need 50% growth on your surplus compounded per year for the next five years in order to achieve your objective.

The 50% will then become your benchmark.

If an investment cannot give you  50% growth on your surplus you will ignore it and if the investment has the potential to give you a growth of more than 50% only then will you consider it.

Next you must determine what risk you are prepared to take on the investment.

One way to do that is to determine how much money you are prepared to “lose” if things do not turn out as you have hoped for.

If you can afford to “lose” R1,000 per month you use this as your risk benchmark and you will not invest more than R1,000 per month.

The risk will be determined by the surplus.

The next step is to find different systems to identify the risk and growth potential of an investment.

I have developed two systems – the Property Pro and Wealth Pro Programs – it also incorporates the Formula for Riches^® as part of the system.

Unless you have a proven system that can identify the risk and the growth potential in an investment you cannot benchmark the investment in order to manage it.

Next is to identify the asset class or classes that will adhere to your benchmark.

The next step will be to apply different financial and life strategies in order to lower the risk and improve the growth on your investment.

The best strategies are those ones where by applying a strategy you will decrease the risk and at the same time increase the growth on your investment.

By managing the different strategies you must find the optimum balance between the lowest possible risk and highest possible growth for your investment in that specific class of asset or investment.  You will learn more about this in the different classes of investment section.

Unless you can measure the results you cannot manage the strategies that you are using to improve the growth and lower the risk.

This is also incorporated in the financial systems that I am using.

The main objective then is to apply different strategies so that your risk becomes smaller and your growth improves.

Once you are applying different strategies you have to manage them because of possible changes to legislation and changes in economic, social and political environments.

Is there a way to offset risk on a property investment?

In the Property The Road To Riches FREE Seminar I will show you how easy it is to mitigate financial risks by using the Property Pro Investment System when it comes to residential property investments.