General Investment Risks & How to Manage Them
Sept 1, 2024
Investing involves risks, and understanding and managing these risks are essential for achieving successful outcomes.
Part A: Common Risks
1. Market Risk refers to the possibility of losing money on an investment due to market fluctuations arising from changes in economic conditions, political events, and market sentiment. For example, you may encounter market risk when stock prices decline during a market downturn, impacting your portfolio value.
- a. Political Risk arises from changes in government policies, elections, or geopolitical events can affect markets. For instance, trade tensions between countries can impact a company’s operation, profits, and stock prices.
- b. Liquidity Risk involve difficulty in meeting short-term financial obligations due to insufficient cash or an inability to convert assets into cash without incurring significant losses. During a global financial crisis, banks may face liquidity risks from a decline in deposits or a rise in withdrawals.
- c. Volatility Risk involve dramatic changes in the price or value of a security, with high volatility meaning prices swing widely. Market volatility can be measured through the Volatility Index (VIX), which quantifies equity market volatility.
- e. Currency Risk arises from fluctuations in exchange rates between currencies. Investors may experience financial losses due to unfavourable moves in exchange rates. For example, if you invest in a Japanese stock that gains 10% in its currency, but the Japanese Yen appreciates by 5% against the Singapore Dollar, your local currency return would be reduced from 10% to 5%.
2. Sectorial Risk or Concentration Risk involves investing heavily in a specific industry or sector, exposing you to risks related to that sector’s performance. To mitigate the risk of overexposure to a single type of asset in case it underperforms, diversification is recommended. For instance, the 2007 subprime mortgage crisis resulted from concentration risk in the financial sector. Banks and other financial institutions had significant exposure to subprime mortgages, which led to substantial losses when the housing market collapsed
3. Capital Risk is the potential loss an investor faces when the value of an investment decreases, possibly leading to the partial or total loss of the principal amount invested. Even seemingly safe assets carry the possibility of capital loss, as there is no guarantee of recovering the full original capital. Investors should be particularly cautious of this risk when evaluating companies, as failure to generate sufficient returns can lead to the loss of invested capital.
In such investments, risk and reward are typically positively correlated: higher risks are associated with greater potential rewards. For example, a risk-reward ratio of 1:5 indicates an investor is willing to risk $1 for a potential return of $5. Standard deviation measures volatility and the risk-reward trade-off of an investment by comparing an individual investment’s return over time to its average return.
Disclaimer: Past performance is not indicative of future results. Higher risk may lead to higher potential returns but also carries a greater chance of loss.
Important notice: The risks outlined above—including, but not limited to, market risk, sectorial risk or concentration risk, and capital risk —are common factors that investors should consider. This list is not exhaustive. It is essential to remain informed and seek professional advice when making investment decisions.
Part B: How to Manage Risk
1. Understand Your Investment Objectives
Investment objectives guide financial decisions and risk
management strategies. Clear goals help determine the level of
risk to take. Short-term goals, like building an emergency fund,
require conservative investments, while long-term goals, such as
retirement planning, allow for greater risk exposure.
Understanding your risk tolerance, time horizon, and financial
aspirations helps tailor your investment portfolio effectively.
2. Know Your Risk Appetite
Risk appetite refers to the level and type of risk an individual
or organization is willing to accept to achieve financial goals.
Factors influencing risk appetite include personal financial
stability, investment objectives, and expertise. A retail
investor should consider existing commitments, such as a house
or car loan, and future cash needs to assess their investment
horizon, whether short-term or long-term.
3. Diversification and Asset Allocation
Diversifying across asset classes — such as stocks, bonds, and
real estate — helps manage risk. Balancing risk and return
involve evaluating potential gains against losses. Regularly
reviewing and adjusting your investment strategy ensures
alignment with evolving circumstances and market conditions.
4. Dollar-Cost Averaging
Dollar-cost averaging (DCA) involves investing a fixed amount of
money at regular intervals, regardless of market conditions. DCA
helps mitigate risk as it reduces the impact of market
fluctuations by buying more shares when prices are low and fewer
when prices are high, thus minimizing the effect of short-term
volatility on the overall portfolio. Based on the example
provided below, consistently investing S$1,000 every month over
four months results in an average cost per share of
approximately S$38.32.
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