Picture yourself getting ready for a tramping expedition…
Plan – Choose your destination. Your financial plan is the roadmap for all those managing your wealth.
Equipment – Investing in one portfolio is like tramping with one boot. Ensure you own a range of portfolios.
Weather – Just like the seasons, financial markets are constantly changing. Make sure your wealth is actively managed to match conditions.
Fitness – knowing your risk profile and emotional bias is like knowing your level of fitness: Essential.
Activity – Managing savings in retirement is entirely different from accumulating wealth for retirement – your investment/savings should reflect this.
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, 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.
Types of Risk
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
- 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. In particular, you should always read the ‘risks’ section of the investment statement, or ask your financial adviser to explain these to you. You also need to know what level of risk you’re comfortable with.
Spreading Your Risks
Spreading your money across different types of investments reduces the effect on your overall portfolio of investments if there is a downturn in one investment type. This is called diversification. Investment research shows that for most people a diversified portfolio results in better long-term investment outcomes. The overall value of a diversified portfolio will change over time and this sort of volatility is a natural feature of long-term investing. For example, you have some shares and some fixed interest investments. The interest rate falls, so when your fixed interest investments come up for renewal you may have to settle for a lower rate of interest. However, the value of your shares may not be affected in the same way. You can also diversify within one investment type. For example, buying several fixed interest investments with different terms is diversifying over time. A financial adviser should be able to provide you with advice on diversifying your investments.