How to create a perfect financial plan - part 3. Understanding risk

25 August 2020

In our last budgeting blog posts, we discussed how to create a perfect budget and helped to figure out where to put your saved money. In the final third part of our "How to create a perfect financial plan" series, we want to talk about risk.

Understanding risk and determining what level of risk you feel comfortable with is arguably the most critical part of your investment decision. Once you understand your risk tolerance and where you are willing to take a risk, investing can become quite easy.

There are four main categories of risk that you should know about:

Investment Risk

Investment Risk is the risk associated with investments going up and down in market value. Some investments are seen as high risk (eg. shares and venture capital) whereas other investments are seen as low risk (eg. fixed income, cash).  

To understand investment risk, you need to understand the risk/return curve. Generally, the rule of thumb is that the higher the potential return from an investment, the higher the expected risk it has (and vice versa).

The level of investment risk you want to take will depend on two things. Your tolerance for risk, and your investment horizon. 

Your tolerance for investment risk depends on how comfortable you feel when the value of your investments falls. One way to figure this out might be to ask yourself "If tomorrow the value of my investments dropped by 20% how would I feel". If it is something that would worry you and cause you to want to withdraw your money, then it's probably better for you to be investing in lower-risk investments.

Investment horizon means how long you want to remain invested for.  If you are able to invest for the long term, then you can afford to take more risk, as you can withstand the ups and downs of the market.

 

Understanding risks

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Concentration Risk

Concentration risk happens when your portfolio is concentrated in one (or a limited number of) investment. If you only have a small number of investments then it doesn't take too much to go wrong before the value of your investments is wiped out.  As well-diversified portfolio can see through many things, when something goes wrong with one (or some) of your investments, other investments can pick up the slack. 

There are a lot of ways to deal with concentration risk - we recommend though that you should always look to own at least 10-15 different investments and ideally you will have both sector and regional diversification. 

Individuals investing in shares are often the ones that are most exposed to concentration risk.  While it might be very tempting to put all of your savings into Tesla or Facebook, that is a very high-risk strategy as if something goes wrong with one of those companies you could be wiped out. Investing through managed funds gives you the benefits of diversification - they will typically have a limit as to how much of a single investment they are allowed to hold.

Liquidity Risk

Liquidity risk is the risk of not being able to access your money when you need it. 

If you have an illiquid asset you might not be able to sell it quickly if you need short term cash. And if you can sell it you are unlikely to be able to maximise value. Investment Property, art and wine are all examples of illiquid assets.  It can take months to sell an investment and you might need to wait for the market to recover to maximise value.

 

Inflation Risk

When you were you young, a can of coke was 50c, now it is $2.00 - the growth in price from 50c to $2.00 is Inflation. 

Inflation risk refers to the risk that the return on your investment does not keep up with inflation. If things are getting more expensive every day but the value of your investments remains flat you are better off taking your money out of investments today and spending it as you will be able to purchase more today than in the future.

Shares and gold are seen to be the best ways to protect yourself against inflation. Corporate revenues and profits should be largely linked to inflation. Gold is a finite resource so the more expensive general things that use gold become, the more expensive gold will also become. 

Fixed income (term deposits, cash and bonds) typically pays you a fixed return. If there is a spike in inflation, the return does not change.

If you're worried about your KiwiSaver, kōura's digital advice tool ensures that your portfolio is carefully constructed and is well-balanced to meet your financial goals and covers your risks.

 

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