Investments and risk tolerance
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TO build wealth over time, an investor needs to accept a certain degree of risk. By taking on very little risk, and keeping the bulk of your wealth in a savings account, you will lose purchasing power over time. As such you are already subject to inflation risk.
The key to managing risk is to first understand the different types of risks associated with various investments. Secondly, it is important to balance your exposure based on your personal level of risk tolerance, financial objectives and expected returns.
Let us first examine currency risk, a risk that anyone converting funds to or from US dollars (USD) in recent times should be very familiar with. Last year alone, Jamaican dollar (JMD) depreciated over 15 per cent against the United States Dollar. Bearing this in mind, it is very important to hedge your portfolio with investments denominated in hard currency (USD, GBP etc.) The simple act of buying and holding US dollars (not necessarily even investing it) would have seen your money appreciate by this amount if you were to convert back to JMD.
While funds intended for liquidity may be maintained in Jamaican currency; one may explore investments that will offer a higher level of return than your typical savings account in order to mitigate erosion of your money by the devaluation of the JMD. Such examples are a BOJ CD (30-day) currently yielding 5.75 per cent or GOJ Treasury Bills yielding an average of 7.42920 per cent (based on most recent auction results dated January 22, 2014).
For longer-term investments, one may consider bonds or the local or international equity markets. Bonds are excellent for investors who seek steady streams of income at relatively higher rates of return. Bonds are usually considered less risky. One of the risks associated with bond investments is default risk, which is the risk of non-payment of either the principal or the interest. Credit ratings by agencies such as Standard & Poor and Moody's will assist in identifying the level of default risk. Bonds with higher credit ratings are less risky and tend to offer lower yields. Buying an investment grade bond below par or at a discount offers a margin of safety.
Stocks are ideal for investors seeking higher yields (both dividends and capital gains) with lower tax implications than a typical savings account or fixed deposit. Including equities in your portfolio will assist in diminishing the impact of inflation and the devaluation of the Jamaican dollar.
This brings me to market risk. Market conditions will affect the overall prices of bonds and equities. Equities are typically considered more risky than fixed income (bond) investments and as such offer the potential for significantly higher returns (or losses, depending on your investment choices). In order to mitigate this risk, it is important for investors to research on the company they plan to invest in and choose companies which are poised for harsh economic times, demonstrate strong growth and have low debt levels. Factors that affect a company's ability to grow include: Management, Profitability, Competitors, Industry Outlook, Current price etc. Another way to lessen the effect of falling market prices would be to invest in strong dividend yielding stocks. These companies are historically known for consistently paying a portion of their profits (usually quarterly) to their shareholders and in most cases growing their dividend payments annually.
Now that we've looked at a few of the main risks surrounding investments, we will explore how to assess your individual risk tolerance.
Age and time frame affect ones risk tolerance. The idea is that the younger you are, the further away your investment horizon is and therefore the more aggressive your portfolio can be. If you are single and employed with a steady stream of income then you can afford to have a higher portion of your portfolio allocated to equities. The opposite is true, the older you get or the closer you are to retirement, you should be more conservative in your investment style. Income and capital preservation becomes the priority.
Net worth or available risk capital is another consideration. Risk capital is money available to invest or trade that will not affect your lifestyle if lost. It should be defined as liquid capital, or capital that can easily be converted into cash. Therefore, an investor or trader with a high net worth can assume more risk. The smaller the percentage of your overall net worth the investment or trade makes up, the more aggressive the risk tolerance can be.
Now consider your investment objectives. Are you investing for your child's future or simply putting your disposable income or risk capital to work to earn additional income? If the objective is the former, then your investment style should be less risky. Otherwise, if it's the latter then you can possibly take on a bit more risk.
Finally, if your investment experience is low, then you should not dive head first in high-risk investments. Take your time and get your feet wet by taking a more cautious approach to investing, learning about the markets and the companies in which you seek to invest in. Your bank account will appreciate you for it.
Knowing your risk tolerance goes far beyond being able to sleep at night or stressing over your trades. It is a complex process of analysing your personal financial situation and balancing it against your goals and objectives. Ultimately, knowing you risk tolerance and having a properly diversified portfolio based on asset class, industry, geography and currency will spread your risk and lower the probability of financial ruin. Also, it is strongly recommended to have a knowledgeable financial advisor to assist you in navigating though the various investment choices and associated risks.
Gillian Bernard is a wealth advisor from the Wealth Division of Stocks & Securities Ltd. contact: email@example.com