Brent Sheather: How to keep that shirt on

Good and bad, night and day, risk and return. They are two sides of the same coin but given the number of disasters that regularly visit themselves on investors perhaps we don't fully understand the nature of risk.

Furthermore, mum and dad may not always be able to rely on their investment adviser to do the right thing: Risky investments typically pay higher fees and commissions than less risky ones.

As we saw a couple of weeks ago (link at end of this article), many truly low-risk assets cannot sustain the fee structures typical locally, thus higher-risk investments often dominate portfolios.

But first a definition of risk: Professional investors see risk as the difference between expectations and results.

Back in 2000 when world stock markets seemed like they never fell, some advisers, using historical data, sold financial plans with unrealistic forecasts.

When reality hit and share prices headed south, things often got nasty.

With a better understanding, perhaps mum and dad will be able to accept some risks and reject others depending on their individual circumstances.

Mismatch risk

Despite the name, mismatch risk has nothing to do with marriage, although that institution can be very risky.

Mismatch risk is simply the risk that the investments you choose may not be suitable for your needs and circumstances.

The best way to avoid this risk is to accurately define your investment objectives - by deciding on the total sum you want to build up, or the annual income you need, and to qualify that objective with a time frame.

It is, however, much easier to invest emotionally letting either greed or fear prevail. A conservative investment may make us feel safer. The prospect of fantastic returns makes us feel richer. It's harder to invest rationally. Understanding Investment Risk includes the objective timeframe investment table, above, that matches investments with time frames.

Inflation risk

Inflation is an increase in the price we pay for goods and services. Because of inflation, $1 today will buy you more now than it will in the future.

Even if the rate of inflation remained at a relatively low 3 per cent per annum, a $1 purchase will cost $1.56 in 15 years.

Inflation risk is thus the risk that the value of your investments or the income they produce - or both - may not increase as fast as inflation. If this happens the real (after inflation) value of your portfolio will fall.

One of the most insidious risks facing long-term investors is the effect of inflation eroding the real value of their income, which is particularly likely if that income comes entirely from fixed-interest investments.

Someone who retired in 1980 and lived another 18 years (realistic given today's life expectancies) and who put all his or her money into New Zealand 90-day bills, would have seen the value of the resulting income drop by about 80 per cent in real terms over that 18 years.

The key to managing inflation risk is to have a diversified portfolio with about half your funds in real assets - property and shares.

Although Understanding Investment Risk doesn't mention it, deflation - falling prices like what happened in the 1930s - is another risk.

It doesn't happen often, but when it does, it can be a big deal because it is harder to fight than inflation. You can protect yourself from the risk of deflation by having some nominal assets in your portfolio - low-risk government bonds mind, not junk.

Interest rate risk

This applies to fixed-interest investments such as bank deposits, government stock and so on. Australian experts say it can be broken down into three parts:

* Credit risk.
* Reinvestment risk.
* Market volatility.

Credit risk is the risk that the company to which you have lent money will become insolvent and be unable to meet interest payments or repay your funds.

We have had some good local examples of credit risk in the past few years and, no doubt, a weaker economy will throw up a few new ones.

A good strategy for dealing with credit risk is to trust no one and buy only bonds with the highest ratings determined by an international rating agency such as Standard & Poor's - such as government stock and SOE bonds.

Reinvestment risk relates to the fact that interest rates can go up and down.

Commentators often judge bank deposits to be low risk and indeed they are if the only risk you consider is the chance of a bank defaulting. But when you consider the volatility of income returns, they can have a high degree of risk.

Back in the 1980s, investors could buy good-quality bonds yielding 18 per cent - today you are lucky to get 7 per cent.

To minimise interest rate risk, we need to spread our fixed-interest investments over a range of maturities.

The other risk, market volatility, arises because some fixed-interest investments, such as government bonds, pay a fixed income (coupon payment) for a long time (sometimes 10 years or more), according to what interest rate prevailed when the bond was issued.

Whether the bond is worth more or less today depends on whether interest rates are now higher or lower than when you purchased the bond and, importantly, on the credit rating of the borrower.

Legislative risk

When you map out an investment strategy you do so on the assumption that laws and regulations won't change.

But what if they do? This is especially important in the superannuation field where governments have made many major changes over the years.

Just recently, the Government has announced its intention to tax capital gains on overseas investments.

This ridiculous legislation, if enacted, could mean major changes and huge costs for many portfolios.

Objective timeframe investment

* Short term (a holiday, appliance purchase). Less than 12 months. Cash.
* Medium term (a home deposit). At least three years. Emphasis on fixed interest with some cash and growth assets.
* Long term (children's education, retirement). More than five years. Emphasis on growth assets (shares and property) with some access to cash.

* Brent Sheather is a Whakatane-based investment adviser.