A Risky World
When they said this month will be a Red October, they didn’t realize that the stock market will be literally in the red.
Filipinos are generally conservative. Surprisingly though, I kept on hearing about people placing hard earned money in equities.
Though equities as an investment can provide potentially good return, one should realize the risk component of such investment.
By now, most, if not all, who are currently invested are suffering big losses.
So if not the equities, I’ve always been asked what investment do I best recommend so that one can have good return without taking risk. Such investment doesn’t exist. Even your friendly and safe “Time Deposit” or “Savings Account” is not totally risk-free.
Risk is the chance that the actual result will differ from what is expected. Two investments, A & B, giving an average of eight percent may sound the same. But examining further, in investment A, one can potentially lose as much as 20 percent and gain as high as 30 percent, while B provides a consistent eight percent yearly. I’m sure that with this additional information, one will most likely choose investment B.
You’re probably told that to eliminate risk, one should diversify and let a professional manage your investments. That is partially true. No matter how you fix your investment and regardless of how much you diversify it, you can never remove risk.
There are two kinds of risk associated with your investment (as an investment or a whole portfolio). One (unsystematic risk) can be diversified and the other (systematic risk) cannot.
This can be diversified. This type of risk is very specific to the asset you bought (firm specific).
Say for example you invested in Company X and there was a massive recall of a product manufactured by that company because they found out it was tainted with poison, or say the company unexpectedly got into a deadlock with its labor union, or even as simple as a warehouse catching fire. This company will suffer great financial risk.
Financial risk will also be high if the company has high level of debt. Another example would be if your investments are overly exposed to one or very few sectors or asset classes. This may be the case if all your investments are just invested in Philippine Equities.
Fortunately, you can eliminate this risk by simply adding different investments and different classes of investments. An asset class is a group of securities that exhibit similar characteristics and behavior in the marketplace.
The three most common asset classes are equities, fixed income or bonds, and cash equivalents or money market instruments that include friendly time deposits and savings accounts.
More sophisticated asset classes would be real estate, commodities, and lately, cryptocurrencies such as Bitcoin. Risk in these assets can be reduced because the other assets in your portfolio can offset the unsystematic risk associated with that asset. If poorly set up though, you may still end up with a high unsystematic risk. On the other hand, a well-planned portfolio will eliminate this risk.
This risk cannot be removed nor diversified away. It is market-related compared to the first one that is firm-specific. Market-related risks may be the macroeconomic variables. Examples of such macroeconomic forces are unexpected changes in the country’s growth rate like gross domestic product, gross national product, consumer price index, industrial production, interest rates, exchange rate, or even the money supply.
In cases like these, your entire portfolio will be affected. Though an asset may be affected more than the other, overall, there is no way for any investment to escape from the impact.
A prime example would be the recent rise in inflation to 6.7 percent. Inflation is the rate at which the general level of prices of goods and services rises and, consequently, the purchasing power falls. This is why it is usually called purchasing power risk. Every Filipino in the country, regardless of social standing or portfolio size, will be affected.
The combination of unsystematic and systematic risks is the total risk of your portfolio. As mentioned earlier, unsystematic risk can be diversified and removed. So if properly done, what will be left is still the systematic risk.
So next time somebody tells you that the investment they are offering is a sure thing, think twice.
Melvin J. Esteban is a Registered financial planner of RFP Philippines. Learn more about personal financial planning at the 73rd RFP program this November 2018. To inquire, e-mail firstname.lastname@example.org or text <name><e-mail><RFP> to 0917-9689774.
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