Investment risk and investment risk management are critical factors for any long-term investor success. Every investor needs to be comfortable with the concept of risk as unfortunately, investing and risk, go hand in hand.

Your investment portfolio is continually subjected to the whims of prevailing market sentiment. All those “known known’s’, known unknowns and unknown unknowns” (thank you Donald Rumsfeld) are continually conspiring to try and alter your fortune!

Now, some investors are able to brush off the effects of risk; while others are ‘wounded’, but will live to invest another day. But sadly for some investors, the effects are so severe it actually takes them right out of the game. And this is the last thing you want, as this type of exit will always be at a loss.

One thing’s for sure, you certainly can’t eliminate investment risk, and still be an investor. That is, every single investment carries with it some type of risk. So unless you actually refrain from investing altogether, it really is something you need to get used to. (On a similar topic take a look at this post about the difference between investing and saving.)

Therefore, as a long-term investor, it’s very important to not only be able to recognize risk, but ac- knowledge its effects, and then ‘work’ in conjunction with it. That way, you will always stay in control.

For example, we’re currently experiencing a cryptocurrency boom, particularly Bitcoins. And, common with all booms, inexperienced speculators join the rush, oblivious to any risk or at the very least, blasé about losing money.

Recently, a friend related a story of someone they knew, who had decided to spend $1,000 purchasing one of the lesser known cryptocurrencies. Their rationale was that the chances of the investment growing 100 fold in the current market was pretty good. But they then added that if it didn’t make ‘heaps’ of money and the investment actually went backward, “all that would be lost was a $1,000, big deal”

Now, either human nature has suddenly evolved a generous and forgiving side since I last advised investors, or I would suggest that this person was sadly misguided as to the value of money! What sort of person just dismisses $1,000 so easily! Oh yeah, that’s right, a really stupid person, that’s who!

To actually value uncertain investment rewards by belittling the initial investment amount is a classic example of investor overconfidence. The possibility of easily accessing profits in boom times overrides any thought of losing money. And any thoughts of loss are assuaged via a very cavalier attitude towards the initial investment funds!

Having experienced plenty of client losses in my time (not always my doing!) I can assure you a loss of $1,000 will hurt alright.

So quite clearly, lot’s of investors fail to recognize investment risk, and in turn, fail to formulate strategies to deal with it. And that explains why so many people actually end up losing money during a boom.

I recall once speaking to a prospective client, whose attitude to investment risk still astounds me to this day. He had come to see me on the suggestion of the lending manager, with whom he had an appointment immediately after mine. The client had $15k in a superannuation fund and was interested to transfer this into one of our own products.

After going through the usual perfunctory tasks of a financial planner I ended up suggesting to him a portfolio comprising growth assets such as local and global shares. Now, you didn’t need to be War- ren Buffett to make this particular suggestion. His funds were locked into the superannuation system for at least another 30 years, so he had plenty of time to ride the market waves.

So I detailed the risks as well as the potential benefits and then sought his opinion. Unbelievably, his immediate response was, “that’s too risky, shares are just like gambling, “I prefer property, it has no risk”

His response was an easy argument to counter and I did so with care and detail, but to no avail, he continued to insist that share investment was just too risky.

It quickly dawned on me that nothing I said was going to alter his opinion so I suggested he think about it and get back to me if he did indeed change his mind. As we walked to the door of my office, I inquired as to why he was seeing the lending manager. “I’m signing up for a loan to purchase a home unit, off the plan, for $440k”! “Isn’t that a bit risky”, I suggested. “Not one bit”, he said, “you can’t lose money buying property”.

Well, you certainly don’t need to be Einstein to see a problem with this guy’s thinking. On one hand, he completely shied away from the suggestion of share investments for a relatively minor amount of money. Of which was compulsorily locked away for at least 30 years. Yet he didn’t even blink at the thought of borrowing 110% of the purchase price for a 2 bedroom unit that had yet to be built. Talk about scoring a perfect ‘10’ on the ‘investor idiot scale’.

By the way, just as an aside, during my years as an adviser, I often asked clients, looking at investment properties, to rate the risk of doing such a transaction on a scale of 1-10. Without exception, each and every person rated the borrowing of money to buy an investment property as a 3/10 risk. It is actually a 10/10 on the risk scale.

So for all of you seriously embarking on a DIY, long-term wealth creation path, risk management will be an essential skill to learn. Your financial goals are achieved through strategic investment, and that includes mitigating your risk factors.

As you have seen many new investors often fail to see the significance of risk – management in their decision making. But as Warren Buffett so succinctly puts it, “The first rule of investing is, do not lose money; the second rule of investing is, always follow rule one.”

I couldn’t even begin to count the times I have seen individuals kick off their DIY investing by calmly proclaiming that they are “very comfortable with market falls”. Only to be reduced to absolute nervous wrecks and subsequent sellers, as a result of a long and protracted market retreat.

So what happened to suddenly change their “attitude”? They didn’t have a risk management plan, that’s what happened.

If you can remember back to those pre-GFC days you might recall the proliferation of know-all investors? You know the ones; the self-proclaimed guru’s who would sit around the office lunchroom, loudly regaling to all and sundry about their investment ‘successes’. Take a look at them now, I bet the investment bravado has well and truly disappeared?

Interestingly, I have always found that the various periods of boom and bust always accentuates human emotions. In boom time, it generally manifests as investor hubris. During these periods there’s a predominance of “bullshit baffling brains.’ A market boom always stirs up massive amounts of in- vestment ‘knowledge’ in people that were certainly not evident prior to the boom! Funny that!

And of course, during the inevitable investment bust, these same investors are suddenly sprouting advice with almost ‘sage-like’ conviction, about how one should “avoid investing altogether, as its far too risky!”

So, the first rule for a long-term investor is to be able to recognize any risks appropriate to a potential investment. Let’s now take a look at some of the more obvious areas risks will come from.

Government

Now, never, ever underestimate the role a Government plays when investing. The actions of our elected representatives can literally destroy an investment with the stroke of a pen. Unfortunately for investors, there are just too many levels to the government to be able to predict what may be on the horizon consistently.

Some changes you just won’t ever see coming, until they’ve happened. But it is important to at least keep abreast of the general thrust of what is occurring in this arena, particularly anything that will impact on our investments.

Thankfully, political journalists are a constant source of up to date information that condenses and explain major government legislation as part of their reporting. So always stay in tune with a variety of newspapers on a daily basis.

Additionally set up a Google alert. Just add the parameters regarding what you are interested in and sit back and wait.

Try to keep on top of both current and pending legislature, and where possible, what’s trending. Usually, the political persuasion of the current government will set a pretty clear agenda to follow,

It is also very important to scour policy speeches of the major parties around election time. This ensures you are up to speed on any proposed legislation affecting your investments should an alternative party gain power.

Technology

The speed of technological change has been and remains just incredible. There are literally thou- sands of new products and processes available today that were inconceivable just 5 years ago. And this pace is only going to accelerate.

It is impossible for individuals to have any idea of just what is around the corner, about to revolutionize our lives. However, it is very important to be able to evaluate and assess the influence any new product or process may have on the investment landscape.

Therefore as an investor, it really is a matter of keeping yourself tuned into all the different forms of media to intercept and interpret new trends, ideas, inventions and anything else that just may change the world. By the way, you are already ‘plugged’ into incredible amounts of incoming information thanks to social media. So it’s just a matter of filtering out all the Kardashian stuff and replacing it with some decent investment stuff if you know what I mean!

It’s also important to remember that much of the technological progress resulting from inventive- ness may not always be perceived as relevant until some future date. So always keep an open mind when researching, especially small-cap and start-up companies. These can quite easily become the blue-chip shares of tomorrow.

A great example of this can be seen in a book called “How I made $2,000,000 in the stock market’ by Nicolas Darvas. Written during the 1950’s it records the true story of a part-time share trader.

Remarkably, it was during the dawn of credit cards making their associated companies the ‘start-ups’ of the era. Well worth reading.

Economic

An economy is the swirling mass of human activity focused on consumption and production. And it’s correct to say that the majority of the world’s countries have evolved into consumer-driven eco-nomies. That is, the action of consumer spending is the major driving force of economic prosperity. Alternatively, reduce consumer spending and the wheels start to slow down and the ‘pain’ begins.

So a clear understanding of the economic conditions of the market you are investing in is incredibly important as it will provide both opportunity and risk.

For example, a reduction of consumer spending will sound the death knell for most asset groups. Whenever consumers reduce their consumption, company revenues begin to fall and this is quickly followed by falling profits. And a decline in profits will result in falling share prices.

But that’s not all. If company profits fall, in order to save costs, companies immediately look at job and wage reduction. This becomes a threat to consumer security leading to further reductions in their spending. Usually, this persistent lack of consumer confidence is manifested during a recession.

So always keep your eye on key economic indicators such as interest rates, inflation, unemployment, GDP growth et al. You are looking for signs that could herald consumer spending slowdowns.

For example, interest rates on the way up suggest a strong economy. But because the government wants to keep growth controlled they begin to dampen down discretional spending by increasing interest rates. This increases consumers debt repayments for mortgages, credit cards, and personal loans and leaves less for ‘frivolous’ spending.

Micro-environmental

Along with major macro risks, there are also plenty of investment risks associated with individual assets.

For example, owning shares in a particular company exposes the investor to a myriad of internal issues that can present as a risk factor. Changes in leadership, high debt levels, lack of product development, bad M & A decisions, you name it, there’s plenty out there to get you.

The answer is to set up surveillance and scrutiny on your investment in order to keep up to date on your chosen company’s progress. A decent part of this will be to understand at least rudimentary details of the company’s financial position.

Referred to as fundamental analysis and utilized as a selection tool by professional fund manager it entails measuring the financial viability of a company. By employing a set of standard accounting ratios, investors are able to create a very clear picture of how a particular company is actually operating.

For those selecting to invest in property, a similar level of analysis is needed. Check councils, local government and state government for zoning alterations, freeway proposals or anything else that may have a future detrimental impact. Investors should also spend the time to ‘eyeball’, target suburbs, streets, and neighbours of a potential investment. A bad vibe in a neighbourhood will certainly reduce profits.

As you can see there is plenty to think about when it comes to investment risk. But a lot of the re- search and analysis I have alluded to in the post is surprisingly simple to complete. Just a dedicated approach and internet access.

The most important factor is to be aware of investment risks and how to deal with them. In the interests of trying to be somewhat concise, I will post the second half on this subject, the strategies to minimise investment risk, soon, so stay tuned. In the meantime, check out this video of an interview with Dr. Harry Markowitz about market risk.

Thanks for reading and see you soon, Homepage.