A Layman’s Introduction to…. Risk

A Series of Articles Inspecting General Financial Terminology

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This is the next in a series of posts looking at some general, basic financial terminology from a non-expert perspective. The topic covered is Risk.

What Is Risk?

Definition

Risk refers to your exposure to financial danger. It is not an objective measure however, risk must be assessed subjectively. For example, an investment that is low risk to me at 35 years old may be a high risk investment to a 59 year old.

Almost all of our personal finances are exposed to some risk. At the low end, our bank account balance is exposed to the risk of the bank failing (however unlikely – although there are some government guarantees in place). At the high end, if a company whose stock we purchased goes into liquidation we may lose our investment. Beyond that, if we leverage our money we increase our risk to extreme levels which could lead us deep into debt.

Often Financial Advisers will attempt to assess risk and risk tolerance on a scale of 1 to 10, so we will utilize the same scale here.

How Do I Work out My Own Risk?

In reference to personal finances there are many categories of risk to consider. Anyone can review risk inherent in any one financial holding or investment. However it is useful to first review risk from a broader perspective. As such risk is typically split into four broad categories:

  • Market risk
    • Stock market crash
    • Interest rate rises
    • Currency fluctuations
  • Credit risk
    • Default on bills or mortgage payments
    • Lack of diversification
    • Country risk (political turmoil, currency control or devaluations etc.)
  • Liquidity risk
    • Asset liquidity (how easily can you convert your assets to cash)
    • Funding liquidity (your ongoing cash flow)
  • Operational risk
    • Difference between planned & actual income/expenditure (error, fraud)
    • External events (vandalism, lawsuits, natural disasters etc.)

Our assessment of the above risks will also depend on our investment time horizon and our willingness to tolerate volatility.

Example

Tammy, 48, has several investments and liabilities:

  • A $48k per year after-tax salary from her job
  • An 80% mortgage ($80k) on her $100k home
  • $150k in an investment account, split evenly between 6 different blue-chip stocks
  • A 65% mortgage on her holiday home in Cancun (approx. $90k at todays exchange rates)
  • $12k in credit card debt

Tammy would seem to be in a good position, with several investments. But what are the risks that she faces?

  • Market risk
    • A stock market crash would damage the value of Tammy’s investment account (8)
    • Interest rate rises will cause her mortgage payments to increase (7)
    • Currency fluctuations could cause her Mexican mortgage payment to increase (or decrease) (9)
  • Credit risk
    • If Tammy misses a morgage or credit card payment, how much will it cost her? (7)
    • $150k invested in only 6 stocks means that if one of her investment choices were to fail it could seriously affect the performance of her portfolio (9)
    • What are the risks of having an investment in Cancun? Could political turmoil affect her choice? (9)
  • Liquidity risk
    • A significant portion of Tammy’s wealth is tied up in her real estate, which is not easy to liquidate should she need it (8)
    • With high credit card debt, she may be trapped in a debt cycle unable to meet her mortgage payments without borrowing from her credit card (9)
  • Operational risk
    • As Tammy only visits Cancun once a year, can she effectively track the costs of her foreign investment from abroad? (8)
    • Does she live in an area at risk from natural disaster (flooding etc.)? (6)

Tammy’s risk profile is 8/10, which is quite high. At 48 years old, she may wish to consider reducing her exposure to risk. This will create a safeguard as she approaches retirement years, protecting her wealth from an untimely change of circumstances such as a stock market crash.

Why Should I Care About Risk?

We all need to regularly review our risk profile as it changes throughout our life. A Financial Adviser will have standardised or mandated risk questionnaires and profiles, but there is nothing to stop you exercising some common sense and self-assessing your risk in the manner of Tammy above. As is shown in the example, though Tammy appears to be financially successful she is in fact open to a number of potentially serious risks. At just ~15 years from her planned retirement she ought to look at protecting herself by investing in safer alternatives that will provide her lower, but more dependable, growth.

What Does Your Risk Look Like at droppedcoin?

I am 34 years old, with an unusual job that has taken me all over the world for the past 10 years. My main risks are:

  • Market risk
    • Stock market crash: I am well-diversified but invested in active funds, which means my fund costs are high. The fund managers need to increase their risk-taking to try to provide higher returns to justify their fees. Needless to say, I am working on moving my funds to cheap passive tracker investments…
    • I have a mortgage and currently pay approximately a 4.5% interest rate. The flat is leased and occupancy over the last 7 years has been approximately 90%, with the rent covering the mortgage payment twice over. Thus I feel comfortable with my current real estate exposure, even in view of increasing interest rates
    • As I work all over the world, I constantly utilize different currencies. In the past I lost a lot of money with poor bank exchange rates. I now utilize 3 banks with accounts in USD, GBP, and EUR, and transfer money with cheap solutions like TransferWise (for smaller sums) and Currency Solutions (for larger sums)
  • Credit risk
    • I am heavily invested in the stock market, and do not invest in bonds. Some may consider this a lack of diversification but I am happy with the higher risk at this stage of my life, since I have many more working years ahead of me
  • Liquidity risk
    • With a single small real estate investment I am not highly leveraged
    • As discussed in the previous post on liquidity I maintain a substantial amount of money to ensure I can always cover anticipated payments many months in advance
  • Operational risk
    • My rental property is several miles from downtown, meaning I am at a higher risk than most of not finding tenants, or having to cut rent rates if the market becomes more competitive
    • My property is insured, but being near to the waterfront means there is a low risk of flooding that an insurer is unwilling to cover

2 COMMENTS

  1. Great discussion. I think more people should look at their own financial risk. To be honest, i haven’t thought about this in a while, but I think my biggest risk would be a stock market crash. I’m invested in equities with no fixed income like you. I do have a decent cash hoard, so I would be able to buy low if the market does come down.

    I think I’m fine on credit risk. I have about $9K on a new car loan at a very low interest rate. I could pay off the loan today, but the interest rate is so low I’m not too worried about it.

    • Andrew,
      Great that you are in a strong position! Totally agree about the car loan, I would do the same but as I move around different countries a lot I have no fixed credit profile – this makes it hard to get a decent loan, so I bought my last 2 cars with cash.
      I found researching this post took me in a different direction than I expected. When I think about risk, I now realize that I probably didn’t look at the whole risk picture. There is so much more to personal finance than just saving some money, and I love how blogging and the community are forcing me to start to open up to all the important information!
      Cheers,
      Paulie

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