Lay(wo)man's Guide to Personal Financial Planning

All investments involve some form of risk. Be very doubtful if someone tells you that a certain investment is no risk and yet will yield a decent return!!

Here, we'll talk about some of the risks:

Market risk

Stock/fund markets are highly unpredictable because there are so many factors influencing the ups and downs. Some of the factors might be (actual or predicted) company earnings, interest rates, unemployment, politics etc. There is absolutely NO WAY to predict market movements (not even for the experts!). Market risk also creates another risk of investors selling at market lows and buying at market highs.

Inflation risk

Inflation is a fall in the purchasing power of money due to a rise in the price of goods and services. Say for example, a packet of fried kway teow costs $3 now. If inflation rate is 2%, the same packet of fried kway teow will cost $3.06 a year later. Inflation is also a problem if prices of goods and services rise quicker than one's income. Hence, it's important to ensure that your investment/savings earnings will keep up with or be in excess of the inflation rate.

Interest rate risk

Interest rate movements will affect both equity investments (stocks and equity funds) as well as fixed-income investments (bonds).

Changes in interest rate will affect the value of bonds more directly than equities and it is a risk to bondholders. As interest rates rise, bond prices will fall and the reverse is also true. This is because, as interest rates rise, bondholders are likely to switch to other investments that reflect the higher interest rate than to hold bonds.

Credit risk

This is related to the financial stability of a company for stocks or bonds. Typically, greater risks are associated with higher rates of return on the investment. For example, in the case of bonds, a company with very strong financial standing will pay low interest rates whereas a smaller company with much less financial stability will have to pay very high interest rate on the bond to compensate bond purchasers for the risk that they are taking.

Currency risk

If the currency in which the investment is denominated depreciates against your home currency, then there's a risk of loss of value in the investment. Such risk is cause by fluctuating worldwide exchange rates. If you invest in foreign stocks or in a mutual fund company that invests in overseas companies, then you'd face a certain level of currency risk.

Political risk

Real, perceived or anticipated political instability can affect the economy which might also affect share prices. During times of war, many investors would prefer to invest in fixed-income investments such as bonds.

Portfolio risk

This risk happens when the investor fails to diversify. A portfolio is exposed to such risk if all the investments are concentrated among certain companies, industries or geographical regions and also if the investments perform similarly during different economic cycles (correlated).

Greed/Impulsiveness

When investors let their emotions get the better of them! For example, mass selling at low prices when the market starts to dip or continue to buy in at high prices when market is peaking due to greed or fear.

Well, here you go...all (if not most) of the risks associated with investments. How then can you avoid these risks? We'll discuss the remedies in my next posting.