What risks do i take when investing?
Most people are worried about investing. They know that there are some risks involved. We all fear losing hard-earned money. Should we really be afraid of investing and rather let the money depreciate by holding cash and inflation? What exactly should we worry about? What are the real threats in asset appreciation and can we reduce the risks? Can I lose all the money with Finax?
We are afraid to invest. Unjustifiably. The main cause is fear of possible loss. These fears stem from the unknown. What we do not understand, we naturally try to avoid because we do not know what we can expect from it and what it would bring to our lives. These feelings are completely natural.
One of these unknowns to us is investing. The perception of risk is very misleading and incorrect among small investors. We are afraid of things that are not a long-term problem for our investments and, on the contrary, we overlook the factors that pose real threats to our assets.
Only when we understand the risk and calculate with it can we successfully appreciate our assets and stop having nightmares about them. Risk is not a reason not to invest. Despite risk, investing is the best and easiest way to increase savings and build long-term assets. Statistics don't lie.
Risk is nothing exceptional, nor should it be perceived as an enemy. It is a natural price for higher yields. Risk is an integral part of investment and every investor must learn to live with it.
Yields and risk are best friends, they go hand in hand and their relationship has never been broken in a fundamental or in a long-term way. If you want to appreciate your assets you have to take risks. If you are not willing to take risks, your returns will remain low and inflation will decrease the value of your financial assets.
Money does not grow on tree and there is no free lunch in the real world. Investments must earn revenue by capitalizing on their business earnings. Every business brings uncertainty.
Investment managers are not magicians who can conjure up returns. Profits must come from something, interest must be paid from something, and it is usually only from the turnover of the company, its income, i.e. the sale of goods or services. Always bear this in mind when considering any investment.
Risks need not to be feared and must be seen as a condition for long-term above-average profits. Risk can be managed. There are ways to reduce it e.g. fundamental investment rules exist. If you follow these rules the investment risk is then out of question.
Risk is generally defined as the uncertainty of the achievement of investment goals. In other words, it is the probability of generating desired returns by a specific investment.
Every proper investment process begins with the definition of investment goal. This may sound amusing, but it will help you avoid disappointment later on. Every goal including the investment one, is reachable by a number of roads, but every one of those roads carries a certain risk, i.e. a different chance of arriving at the destination.
The very first and one of the most important risk management tools, that should be used even before starting with investing, is choosing the right portfolio composition. Investment adapts to the goal, its parameters, conditions and the nature of the investor such as the investment horizon, financial situation, expected return and risk tolerance.
Based on them, the investor chooses the right composition of the investment (allocation), i.e. the proportion of different classes of assets carrying different returns and risk. In general, bonds are a safer investment with less price fluctuations, but also with lower long-term returns, and equities are a more volatile investment with higher long-term returns.
Of course, the investor must keep his feet on the ground and his expectations must be realistic and achievable. The probability of meeting the investment goal should be, when correct composition of the investment is chosen, as high as possible, i.e. keep its risk as low as possible.
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The risk-free investments in the financial world are considered to be government bonds of developed countries, especially the USA, Japan and Germany. Equally risk-free investments can be considered bank deposits for individuals up to 100 thousand EUR guaranteed by the Deposit Protection Fund, i.e. the state.
However, yields also correspond to low risk. German 10-year government bond today offers a negative yield of -0.2% per annum, i.e. that investors are paying the largest European economy for lending money to it. Deposits in banks today offer practically zero interest.
If your target is to at least outperform inflation with the return, you have no choice but to take the risk. In general, any return above the risk-free investment level carries some degree of risk.
We divide investment risks into two basic groups:
- Non-systemic risks (specific)
- Systemic risks (market)
This group includes the individual subjective risks relating to a particular security and its issuer (issuer - company or state). It is specifically related to the business to which you lend money through the purchase of a bond or in which you invest directly by buying shares. We also include here the risks inherent to the investor himself or his investment manager.
Risk of business is the most common risk of an individual security. This may be any event or reason that will hinder the company’s expected economic results or when its value falls.
Example of this are low quality of products or services, low demand for them, high expenses, weak market share, industry development, company management, bad accounting, bad business strategy, failure to achieve plans, scandals, violations of law, lack of innovation and anything else that lowers the company earnings, profitability or leads to the sale of shares by investors and decline in value of the company.
A certain subset of risk of business is credit risk that is only applicable to bonds and other debt securities such as bills of exchange, certificates and others. Credit risk is the probability that the entire principal of the bond or that the bond coupon interest will not be paid out.
The causes of non-payment correspond to the risks of business. Every debtor borrows money in order to invest them in a business, from which he must inevitably return the deposited funds and, in addition, the agreed interest. If he fails, credit risk is implied.
The most effective method of minimizing or even eliminating the risk of doing business is broad diversification, that is a distribution of investment among a large number of individual securities.
Risk of business can also be eliminated by thorough and fundamental investment analysis and the application of an effective investment strategy, but as history and experience show, their effect is not sufficient and carries other specific risks.
These are human risks and investment strategy risks. Although most of us deny it, we are mainly driven by our emotions, but they are also the biggest enemy of investment. We think that our decision-making is rational, but it is primarily controlled by the psyche.
Human decisions are due to our feelings often prone to error, which ultimately leads to weaker long-term performance of actively managed investments. But professional investment managers are also prone to these errors. This is perhaps the most underestimated and at the same time the most significant investment risk.
The solution to the risk of business or similar specific risk may be a specific investment strategy to which the investor adheres to. However, no strategy is universal and each one works under certain conditions, but lags behind or brings greater risk in others.
The most effective way of eliminating human risk is a passive approach to investment, i.e. investing in the entire market without actively selecting securities or trying to buy and sell investments at the right time.
This is an objective, general risk arising from the development of society, stock markets and the economy. It is not in the power of the investor to influence it significantly. Economic cycles, i.e. alternation of expansion and correction, are natural.
Systemic risks can include general market sentiment affecting index movements, macroeconomic developments, as well as political risks (currency and fiscal levels). Related, more specific risks are currency, inflation and interest rate risks.
Market risks can be described as natural and completely unavoidable. In reality, they are the least harmful risks to your investment as long as you follow the basic investment rules. Paradoxically, we are mostly concerned about systemic risks.
Market risk are always taken care of with time. This risk decreases to zero as the investment horizon increases. Financial markets have always recovered from every recession and have always reached new highs. Sufficient time is fundamental and most important condition for successful investment.
As Pavel Škriniar from the University of Economics in Bratislava says: “Investing is like baking a cake. You will not take it out of the oven after 5 minutes and eat the cake unfinished. You also have to be patient with the investments and let them be in an oven for the time required, not eating them before the horizon.”
The change of the value of the investment is what causes anxiety in us. We are worried about a possible fall of the prices of securities held. But their trading is a huge advantage. Thanks to it you can always react quickly to change in your life situation or you can change the investment itself.
At any time, you can sell or even buy an additional investment and you can be certain that it is fairly valued at any moment by a huge number of market participants. Because of this you always know how the market perceives your investment.
We, on the other hand, subconsciously and erroneously prefer non-volatile investments, such as private bond issues. But which investment carries more risk? Investing in the 5,000 largest global companies with trillion turnovers worldwide, or a loan to a local apartment building company with minimal capital and zero assets?
The 5,000 biggest companies will not disappear from the world map. With a sufficiently diversified investment, you can never lose everything and the decline in value is always temporary. But once the company you lent money goes bankrupt and doesn't pay out the bonds, no one will be able to return the lost money to you. So, what is a riskier investment?
Another useful market risk management tool is the right allocation (portfolio composition) already mentioned at the beginning. Unless I am willing to bear the risk and cope with the fluctuations in investment, I cannot expect high returns. Similarly, if I am not able to give the investment sufficient time, I cannot invest dynamically.
But these are no reasons not to invest. We can invest with different risks. Portfolios with a higher proportion of bonds are suitable for shorter periods and for more cautious investors because they have significantly lower value volatility. This can be seen in the following graph.
It is also advisable to deal with market risk by investing regularly, because of this the purchase prices will average out in time. As a result, we buy more shares and increase our financial asset.
Other market risks such as currency, political and interest rate risk are effectively eliminated again by sufficient diversification.
What risks do you take with Finax?
When we founded Finax, we had a wealth of experience in investments and financial markets. We used this experience to create Intelligent Investments. We have not turned our back on the risk as an integral part of investment.
Portfolios have been designed with great emphasis on minimizing the vast majority of risks:
- risk of business and credit risk are virtually zero - no one in Slovakia will offer you such a diversified portfolio as Finax, in which you can find 9.5 thousand equities and bonds from all sectors of the economy,
- passive investment, which embodiment is Finax, completely removes any human and investment strategy risks,
- broad diversification among securities from 92 countries on all continents significantly reduces political and currency risks;
- You do not have to worry about choosing the right allocation based on your goals, risk profile or horizon - our platform will select the appropriate risk-based portfolio that will suit your goals.
- Invest monthly starting at just € 20 – you only have to set up a standing order,
- the only risk left is the market risk that can be eliminate by providing a sufficient investment horizon for your investment,
- Then all you have to deal with yourself is to correctly assess your life situation, your plans, expectations and your character, give at least part of your savings enough time to work, maintain discipline and not succumb to emotions prematurely.
The ideal investment achieves maximum yield with minimal risk. We hold the opinion that we are in this area the best on the Slovak market.
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In the upcoming months, we will continue to publish more articles and webinars about the proper setup and management of personal finances, investment plans, as well as the risks of various types of investments.
If you want to invest with minimal risk and get the most out of it, move your investments to Finax and get a discount - 10% of the value of the transferred investment will be managed for 5 years free of charge.