Learning about shares: Managing risk a classic quandary

Olympic champ and new investor BARBARA KENDALL gets help from NZX's Dan Dividend

Barbara asks: We talked about the concept of risk over the summer holiday. I decided that my investing style leans toward long-term investments that will grow my money over time, rather than reaping short-term rewards.

I'd like to know more about risk. Is it good or bad? How do investors manage risk to safeguard their money?

Dan Dividend responds: Risk is the chance you take that the return on your investment will be different to what you had expected.

Love it or loathe it, risk is here to stay - it's present to varying degrees in all your investments, whether they're shares, property, your brother's new business or bank deposits.

The more risk you take, the greater your potential return (and potential loss). The upside of risk is that you might make enough money to retire, buy an island and a super yacht to take you there. But you could also lose all the money you had invested.

Conversely, lower-risk investments that carry a higher degree of certainty tend to earn lower returns.

In the sharemarket, risk is closely linked to share-price volatility - the day-to-day rise and fall of prices.

Active share traders love risk, using it to make short-term gains. Of course they may lose money too, but they trade on the basis that their gains outweigh their losses.

For people at the other end of the scale, risk is the monster hiding in their wardrobe keeping them awake at night.

It's often said that you shouldn't lose sleep over your investments. If you do, you should re-assess how much risk you are prepared to take.

Most people find that their tolerance for risk falls somewhere between the above scenarios.

So I'm afraid there's no straight answer to the question "is risk good or bad?"

It's different for everyone, and you should make investments that suit your risk tolerance. We'll talk more about this in the next few articles.

For now, let's look at how you can manage risk in your investing. I'll call on Carmel Fisher of Fisher Funds Management to help.

Carmel says: As Dan mentioned, every investor should assess where they sit on the risk tolerance scale. Are you prepared to take a lot of risk for the chance - not guarantee - of quick, high returns? Or do you want to safeguard your money and watch it grow over the long term?

A couple of measures you can take against risk are diversification and taking a long-term view of investing.

Diversify

Diversification in share investing means buying shares from a variety of industry sectors to minimise the overall risk in your portfolio.

Imagine you bought shares in three retailing companies. Your returns would be dependent on the retail sector's performance - it would be like putting all your eggs in one basket.

Here's an example. Retailers tend to do really well around Christmas. However, last Christmas was a disappointing shopping season. Many retailers announced lower-than-expected sales results and their share prices fell.

To reduce your exposure to the ups and downs of any particular industry, you could buy shares in, for example, one retail company, one utility company, one healthcare provider.

That way your savings aren't at risk from a fall in the share price of one particular company.

You can also diversify by including other investments in your portfolio, such as funds and debt securities (bonds). Another technique is varying the company sizes in your portfolio: from large companies listed on the NZSX 10 (the top-10 index) to emerging companies with growth potential.

Invest for the long term

If you are uncomfortable with the higher risk associated with investing in shares in the short term, you should treat shares as long-term investments.

Pick quality companies and grow your money over the long term, without overly concerning yourself with day-to-day share price fluctuations.

History has shown the sharemarket to be the best place to put your money in the long term, consistently beating all other major investment classes including property, bonds and bank deposits.

* NEXT: We'll continue the discussion of risk and diversification.

* GOT A QUESTION? Feel free to email Dan Dividend with your questions.