Reduce Risk To A Probability

By David McEwen

Saturday 6th October 2001

Many investors say they are prepared to take high risks in the pursuit of high profits. Most are wrong. When an investment starts going down in value, feelings of nervousness quickly start to surface.

The trouble is, people only discover their lack of risk tolerance once their investment has lost value. By then, it can be too late to recover all of their initial capital.

The reason there is such a gap between what people believe about their risk tolerance and reality is that they don't try to quantify the risks they are taking. Many just focus on the huge returns they hope to make.

Before one tries to measure risk, it helps to define it.

Investment experts often try to label it in terms of volatility, liquidity and even stupidity (of other investors, of course). The average investor is likely to see it in black and white terms: Will I lose my shirt?

These views obviously have an influence on the prices of assets, but the definition I like best comes from investment bank Merrill Lynch. It says, "Risk is most clearly defined as 'the probability that a plan will not meet its long-term objectives'."

The key word here is 'probability'. Risk is not necessarily some unmeasurable threat to one's hard earned savings. If types of risk can be quantified, then investors have a better chance of managing it.

A good place to start is to figure out what is the safest investment and what is the riskiest.

Government stock is normally referred to as 'risk free' because a government has the ability to raise taxes if it can't meet its liabilities. Of course, there is always the risk that the government won't be around or the sun won't rise tomorrow, but the chances are so low as to be ignorable.

Therefore, an investment in government stock has effectively a 100% chance of being repaid, with a bit of interest.

At the other end of the scale is something like a lottery ticket, where there is only a tiny chance of getting your money back, albeit with up to several million dollars more besides.

All other investment assets fall between these extremes.

Figuring out the exact chance of losing your money, or what return you will get for the risk taken, is impossible - although one can take an educated guess.

Because of this uncertainty, having your money in more than type of asset is important. Such diversification means you are more likely to hang on to the bulk of your portfolio if something unthinkable - such as an audacious terrorist act - were to happen.

When a shock occurs, higher risk assets are less popular with investors and tend to fall steeply in value. Low risk assets fall less and sometimes even go up.

Therefore, it helps to own a combination of low, medium and high-risk assets. The amount put into each depends on how much you can stand to lose and what kind of return you want.

In these uncertain times, when markets are volatile, it's hard to know whether to buy, hold or sell.

However, a decision can be easier to reach if you decide how much you can stand losing in a worst case scenario - and assess the probability of that scenario occurring.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz.

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