“The biggest risk is not knowing what you are doing,” Peter Bernstein, American financial historian and economist.
All investments come with a level of risk. As an expat investor, it’s important to understand your portfolio’s inherent risk, as well as what level of risk you are willing - or what you may need - to take to achieve your goals.
As well as general risk levels, expats also have other risks to consider, such as tax implications in multiple countries and cross -border investing currency risks, which we look at in another article.
In this article, you'll learn about the following topics:
• What is Investment Risk?
• What is your Risk Tolerance?
• What is your Risk Capacity?
• What is your Required Risk?
• Determining an investment’s risk
What is Investment Risk?
Investment risk is Investment risk is associated with the uncertainty and/or potential financial loss inherent in an investment decision.
Some investment risks are avoidable by choosing safer investments, whereas other investment risks are considered unavoidable, such as:
• Market risk - Loss in investment caused due to various macroeconomic and political events that affect the entire market.
• Inflation risk - Loss of your money's purchasing power. Usually, safer investments like bonds yield low returns that may be lower than inflation.
• Interest rate risk - Central bank interest rate changes can impact bond payments and also company liquidity and markets in general.
• Currency risk - Currencies constantly fluctuate in value in relation to each other, so there’s a risk that your investments’ value decreases in relation to the currency you want to spend it in.
• Socio-political risk - Political and social movements and changes in the country where you’re investing (or in other countries) can affect the value of your investments.
In theory, risk and reward are directly proportional to each other when investing. That is, the higher the risk, the more the reward, and conversely, the lower the risk, the less the reward.
For example, bonds are traditionally considered a safer investment than stocks, as they provide steady interest payments and the return of the capital even if the company (or government) isn’t performing well. In contrast, stocks provide no such guarantee, but the additional risk is compensated in the form of greater expected returns. This view means that more risk-averse investors often hold a higher proportion of bonds compared to stocks in their portfolio, to maintain a lower overall investment risk.
Typically investors start their journey by seeking investments associated with high expected returns - why bother with lower expected returns, right? Unfortunately, many investors are not aware that these investments are riskier, and as a result they end up incurring unexpected losses. This is why it is crucial to evaluate before investing what your risk tolerance is, what your risk capacity is, and what your required risk is.
What is your Risk Tolerance?
Risk tolerance is the level of risk that you’re willing to endure to achieve your investment goals. Your financial advisor will need to gain an understanding of your risk tolerance to be able to advise you in terms of what you invest in.
To determine your risk tolerance, you’ll normally consider the following factors:
• Your age - Generally speaking, younger people are often more comfortable taking risks in the pursuit of long-term gains, as they have more time to recoup possible losses compared to those closer to retirement.
• Your personality - People with a more adventurous nature may have a more aggressive attitude towards their investment portfolio, and so may be comfortable with high volatility and risk levels.
• Your investment goals - Your goals should ideally be the most important factor that determines your investment risk tolerance.
Box - Risk Tolerance Illustration: Someone in their 30s planning for retirement has over three decades to save, so they have a good degree of freedom to take risks with their investments. Someone in their 40s planning to send their children to college in a few years on the other hand will need to ensure that they have funds available at the right time, as the payments will be required on a fixed date that can’t be deferred.
Based on the above factors, risk tolerance is often classified into 3 levels. They go under different names by different firms and advisers, but they can be summarized as:
• Aggressive Risk Tolerance- Investors willing to risk losing money to achieve higher gains.
• Moderate Risk Tolerance- Balanced investors who want to focus on growing their money but without losing too much.
• Conservative Risk Tolerance- Investors willing to take very little risk or accept very low volatility in order to preserve their capital.
What is your Risk Capacity?
Risk tolerance is how much risk you want to take, while risk capacity is how much risk you are able to take to achieve your goals.
The following factors determine risk capacity:
• The time horizon of investment - When you will want to start drawing down your investment
• Investment size, additions and withdrawals - The size of your investment portfolio relative to future additions and withdrawals.
• Investment income vs other sources of income - How much of your future income depends on your investments.
An example to help you assess your risk capacity: If a couple have saved $40,000 as the down payment for a house they plan to buy in 2 months, their time horizon is short and the future withdrawal is large (100% of the investment), so they therefore have zero risk capacity. But if the same couple saved more, say $75,000, and they don’t plan to buy the house for another few years, then they have a higher risk capacity and so might decide to look for higher returns in the meantime.
What is your Required Risk?
Required risk is how much risk you will need to take in order to achieve your investment goals.
The greater the return you need to achieve from your investment, the higher the risk you will have to take to achieve it. This means that sometimes there can be a disparity between your risk tolerance (how much risk you want to take) and the required risk (how much risk you need to take); if so, you will either have to reevaluate your goals, or accept a higher investment risk than you would normally feel comfortable with.
Determining an investment’s risk
All investments have a degree of risk, and it can be measured in different ways depending on the asset class involved.
For example: when investing in stocks, a metric called "beta" is used to measure the volatility of a stock in relation to overall market movements. If a stock’s beta is greater than 1, then the stock is considered more volatile than the market in general, whereas if the beta is less than 1, the stock is less volatile, and so is a safer investment.
Other factors that can help you evaluate an investment’s risk level are
• Its historical profitability
• Its historical growth rate
• Its current value compared to its historic average value
• Its dividend history
• Probable sustainability
Every investor needs to assess their risk tolerance and capacity and seek professional advice before making investment decisions. Risk can be mitigated by strategies such as diversification and natural hedging to create a balanced portfolio with risk levels you’re comfortable with to achieve your goals.
While it’s been said that if you subtract your age from 110, you can use the resulting figure to determine what proportion of your portfolio should be in riskier stocks, this doesn’t take into account your personal risk tolerance or goals. Your financial advisor will help you make a better balanced and more holistic assessment.
If you have any questions, don't hesitate to contact us.
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