Money: Risky? It's all in how you see it

By MARK FRYER

It's one of the most-quoted investment cliches in the book - "to get higher returns you must accept a higher level of risk."

Trouble is, the experts' definition of "risk" tends to be very different from the way investors use the word.

For most of us, risk means the danger of losing our capital - the chance that the company we've invested in will go bust, making its shares worthless, or that the finance company won't be able to repay us when the term deposit is up.

So does the old saying mean that to get the best returns we should invest in the dodgiest enterprises we can find? Hardly.

The confusion arises because of the different ways of interpreting that crucial word, "risk."

When professional fund managers and advisers use the word, there's a good chance they're thinking about something quite different from the chance of losing all their money.

That something is volatility, or how variable the return on a particular investment tends to be.

Assuming you have a diversified mix of investments, "when you are talking about risk you are talking about ... the variation in return," says Aaron Hing, head of financial advice with Spicers Portfolio Management.

"It's not actually the risk of losing your money because we believe that the world would have to end before a well-diversified portfolio was wiped out."

So when the professionals describe an investment strategy as "high-risk" they mean the returns are likely to fluctuate, rather than rise smoothly.

Risk's multiple meanings can be a source of confusion.

"More and more we have been using the word 'variation'," says Mr Hing.

Whatever you call it, variation or volatility gets a lot of attention in the investment world, and there is a small industry devoted to measuring the volatility of everything from an individual share to an entire market.

The mathematical measures the analysts employ - standard deviations, alphas and betas - may be a mystery to most investors, but the basic idea is simple enough.

Take two shares, A and B, both selling for $1. They both rise an average 10 per cent a year, so after five years they will each be worth $1.61 (10 per cent compounded five times).

So far they're equal. But during that five years share A rises 10 per cent every year, regular as clockwork, while B is up 20 per cent one year, down 10 per cent the next.

Long-term, the two shares produce exactly the same return, but share B is the higher-risk option.

Volatility matters a great deal to fund managers and anyone else whose success or failure is measured in their investment returns. It's all very well producing great long-term gains, but if your fund suffers too many sharp falls along the way it's going to be hard to attract new investors, or keep the ones you already have.

Volatility also matters to individual investors; if you have to sell your investments when they're going through a down patch, the fact that they have great long-term prospects won't be much comfort.

And if you're the nervous type, too much volatility will make it hard to stick to even the best thought-out investment strategy.

This whole question of volatility is not just a matter for the number-crunchers. Being aware of your attitude to risk can play a major role in working out the best investment strategy.

If you're risk-averse, for example, it would not be a great idea to have a portfolio made up entirely of shares, which are almost guaranteed to provide a few sleepless nights even if they do produce good long-term gains.

Working out your risk tolerance should be an important part of seeking investment advice (and if your adviser makes no attempt to do so, it might be time to find a different adviser).

Australian company ProQuest, which specialises in assessing investors' risk tolerance, says people generally do not accurately estimate their own capacity.

Most of us, says ProQuest, are more risk-avoiding than risk-seeking - given a choice between a certain profit and an uncertain but probably larger profit, a sizeable majority of us choose the certain (but probably smaller) profit.

ProQuest suggests that working out your risk tolerance can be helpful when dealing with an investment adviser - especially as advisers tend to be much readier to accept risk than the population at large.

It also says it can be a valuable step for a couple making financial plans, because they may find their attitudes to risk are very different.

But whatever your attitude, if you're going to invest, there's no way to avoid risk.

If you're too cautious, you'll earn relatively low returns. If you're not cautious enough, you may get some nasty surprises.

The connection between risk and return may be easy to accept in theory, but it's a little harder when you confront it in reality.

Yes, international shares have produced good long-term gains, but how would you react if the value of your shares fell 20 per cent or more? That's not an academic question; if you invest in US shares, for example, you could expect to suffer a reversal of that size once every five years or so.

Could you stick with your share investments if their value almost halved? That's what happened to the US market between January 1973 and October 1974.

Fortunately, although it is impossible to avoid risk, there are ways of coping with it.

Step one is to work out how much risk you can afford to take. There are various approaches to this, ranging from sophisticated questionnaires to a discussion with an adviser, but among the questions to ask yourself are:

* How old are you? If you're relatively young, your investments have time to recover from any temporary setbacks, so you can probably afford to take more risk than someone approaching retirement or already there.

* How long are you investing for? If you're saving for your first home in three years there's a good chance that a volatile investment, such as shares, could be down at precisely the time you want to get your money out. If you're thinking 20 years ahead, you can take more risk.

* What's your worry threshold? Some people accept gains and losses calmly, others start fretting every time their investments fall. If that's you, there's no point pursuing the best-possible returns if you're going to be miserable.

* How high are you aiming? If you're perfectly comfortable with your investments just keeping up with inflation, term deposits may be all you need. If you're looking for a higher return, you're going to have to accept more risk.

* How are your finances? If your income is reasonable or better, you can tolerate more risk than someone who is living hand-to-mouth. If you don't have many debts you're also in a position to take on more risk, and if you already have existing conservative investments you might be more inclined to try something riskier.

* What about your personal situation? If you're healthy, you might be willing to accept more risk than you would if you are plagued by health problems. Ditto if you're in a stable relationship rather than facing divorce or separation.

While risk tolerance is important, it's not something you can consider in isolation. If you decide you can only tolerate a minimal amount of risk, for example, but want the best-possible returns, something has to give - you either have to accept a lower return than you'd like or be prepared to run more risk than you'd prefer.

A vast amount of research has been devoted to constructing investment portfolios that are at what the experts call the "efficient frontier" - the maximum possible return for a given level of risk. However, any investor can go a long way to countering risk with three simple techniques:

* Diversify. Rule number one for the risk-aware. Otherwise known as not putting all your eggs in one basket. The idea is to spread your investments across several areas which aren't, as they say, "positively correlated," or in everyday language, aren't inclined to go up and down together.

Investing in one company's shares would be the ultimate in non-diversification.

Spreading your money across a dozen New Zealand companies would be a little better, but still would not give you anything like a diversified portfolio.

Spreading your money across shares in several countries will even things out more, and adding some fixed-interest investments and maybe some property will get you much closer to a diversified portfolio.

* Take the long view. Assuming you've got a well thought-out strategy, don't quit when your investments fall, and don't worry about checking their value every day.

* Take the gradual approach. Rather than investing all your money at once, try the drip-feed approach as a way of minimising the chance that you'll invest at the wrong time.

* Contact Personal Finance Editor Mark Fryer at: Business Herald, PO Box 32, Auckland. Phone: (09) 373-6400 ext 8833. Fax: (09) 373-6423. e-mail: mark_fryer@herald.co.nz.