Managing Financial Risk
Our recent blogs have discussed some of the risks present when investing, the importance of identifying risk capacity versus risk tolerance, and in this article, we discuss how investment risk can be managed, or can it?
It’s important to recognise that commentary regarding managing investment risk, is a little misleading, yet it is often discussed. The future is not known, the past is not always a good indicator of the future, yet some financial articles discuss managing risk as if it can be controlled and foreseen. We recommend you review part 1 of this series, identifying investment risks, as we highlight there are many elements that create investment risks, and it is simply impossible to control the things we cannot predict.
So, when it comes to ‘managing’ investment risk, we are really talking about the possibility of reducing the potential for capital loss when our money is exposed to assets that change in value, i.e., things like shares or property.
Before we expand on some considerations for reducing investment risk, we re-iterate the importance of knowing why you’re investing in the first place. We also recommend you review part 2 of this series on risk capacity which discusses this in more detail.
Reducing core Investment Risks
One of the most effective ways of reducing investment risk is via diversification of assets. This is simply, not having too many eggs in any one basket. However, in Australia, we tend to have a domestic bias when it comes to investing.
Recent data has suggested that over 50% of invested capital outside the family home by established affluent investors is concentrated in Australian residential property and Australian shares with only 4% directly invested in international shares. This group is estimated to have wealth in excess of $4 trillion[1].
To put this in perspective, the International Monetary Fund indicates Australian GDP in 2022 will be $2.1 trillion which is 1.6% of the global economy[2]. So, this data highlights many Australian investors have over half their wealth invested in a pool that covers less than 2% of the global economy and is concentrated in 2 asset classes.
Australian residential property has been a very good investment for many. Whilst there may be some unique attributes to our property market regarding supply and demand that supports long-term growth, this does not mean residential property cannot go down in value, because it can. Therefore, it is important to diversify your wealth.
We should also recognise the unique and positive attributes of the imputation system in Australia; this is also known as franking credits. Very useful for income and tax benefits. However, the ASX is in itself highly concentrated with the top 20 companies making up a significant portion of the index. With such a large concentration to domestic assets for many investors, there is a lack of diversification.
Diversification for Australian investors provides several opportunities to reduce overall wealth portfolio risks as different assets can behave differently at different times and economic cycles, so having a broader, yet strategically constructed, diversified portfolio of assets should be considered.
Diversification does not just mean investing in shares in another country. True diversification is to reduce risk, to do this, you need to be investing in assets that have a low correlation towards one another as well as avoiding concentration to a limited number of assets.
Investing with diversification can provide:
– Opportunity to invest in some of the world’s most successful companies outside Australia
– Opportunity to invest in other economies at different cycles to Australia
– Opportunity to add diversifying assets to a portfolio
– Global infrastructure
– Foreign Exchange
– Global Fixed Income markets (where rates will likely rise quicker than Australia)
– Global commercial property via managed funds
– Commodities
Market Timing Risk
In addition to diversification, being aware of what you’re investing in, and the timing can help you reduce overall portfolio investment risk. We’ll cover timing risk in more detail in other posts and articles, for now, an example is Government or Corporate Bonds.
Traditionally, a defensive investment given bonds have historically been uncorrelated to equities (shares) and provided a defence to inflation and falling share markets. Now, we have a problem with bonds. The real capital value of a bond can fall when interest rates rise. Given interest rates are more or less zero, the future capital value of a traditional bond investment can be at risk. This is the opposite of the function of the investment as a defence strategy.
So, right now, there is more investment risk in a traditionally defensive asset.
We are currently in a challenging environment. Getting the balance right in your investments needs careful and professional consideration. We encourage you to get professional advice from a suitably qualified professional to assess your investment risk and discuss how you can reduce it.
Important: We do not consider cryptocurrencies to be an investable asset class and will not provide advice in relation to cryptocurrencies. We encourage you to consider the implications of potentially supporting Russia in the war on Ukraine by investing in crypto as this is an unregulated market.
General Advice Warning: The information in this communication is provided for information purposes and is of a general nature only. It is not intended to be and does not constitute financial advice or any other advice. Further, the information is not based on your personal objectives, financial situation or needs. You are encouraged to consult a financial planner before making any decision as to how appropriate this information is to your objectives, financial situation and needs. Also, before making a decision, you should consider the relevant Product Disclosure Statement available from your financial planner.
Whilst we have provided reference in this article to data provided by Netwealth, this is not an endorsement in any way for Netwealth products or services and we have no affiliation with Netwealth.
[1] Netwealth, Research Report, ‘The Advisable Australian’, 2022.
[2] International Monetary Fund, 2021, World Economic Outlook, October 2021; Austrade
