Investment risk questionaire

**jIM_Ohio** · 01-07-2010, 09:18 AM

The purpose of this post to have a place for me to refer people to this link if they are trying to decide how much risk to take.

If you are new to investing for retirement, please do not let others tell you how much risk to take. Educate yourself to what risks exist, and be comfortable with the risks you know about and are willing to take.

If you have other factors which influence risk, feel free to comment. This same post will appear in forums soon.

INVESTMENT RISKS
Nothing is risk free. Nothing. There are many types of risks. Do you know what the following risks are?
a) market risk
b) principal risk
c) interest rate risk
d) currency risk
e) investment risk
f) geo political risks
g) information risk
h) sector risk
i) liquidity risk
j) inflation risk

I will give some examples of the above.

Market risk is the risk most people talk about. Its the concept that you invest $5000 today, and the market's movements up and down take away some of that $5000 you put into your IRA this year. Could be 10% of it ($500) or could be 50% of it ($2500). You have no control over the market's movements either. If you invest in stocks and bonds, you subject yourself to market risk (or risk of principal).

The best way to lower market risk or principal risk is to do any of the following:
1) own more than one mutual fund or stock or bond or investment type.
2) Keep some money in cash

Interest rate risk. If you invest cash, you take on this risk. Interest rate risk takes on two facets- one facet is that you put money into your savings account or money market account, and the rate the bank charges you interest changes daily. Invest today, get a 1.5% rate... rates tomorrow change and you get a 1.3% interest rate, 2 years later rates change and you are getting a 6% interest rate. You have no control over the rates the bank is giving you.

The second type of interest rate risk is the idea you lock in returns with a bond or CD, and the changing of interest rates affects the value of your investment. For example if you put $2000 into a 24 month CD today and the bank gives you a 2.5% interest rate, you have the risk that the rates go up tomorrow and the same bank offers a 3% interest rate on a 24 month CD. You also have the reverse benefit- if you invest $2000 in a 24 month CD at 2.5% today, and rates go down tomorrow, you have your 2.5% locked in.

Similar behavior happens with bonds, you can purchase a $10,000 bond, and it will give you a guaranteed rate (depending on the bond, these rates can come from inflation or intesest rates). If your $10,000 bond pays 5% and interest rates change, the value of the $10,000 bond will change (if rates go up, the $10,000 bond is worth LESS; if rates go down, the $10,000 bond is worth MORE). If you hold the bond to maturity, you can remove interest rate risk from changing the value of the bond. If you own a bond fund, you will see the value of the fund change as rates change. If you want to know more about how changing interest rates affect bonds, ask questions. It depends on the type of bond as to how a bond will react to changing interest rates. In general, rates go up, bond value goes down; rates go down, bond value goes up. If you hold bond to maturity, the risk interest rates on the bond value is eliminated.

The way to deal with interest rate risk on bonds is to own bonds with varying maturities. Ultra short (less than 2 years duration on until bond matures), intermediate (bond matures between 5 and 10 years from now) and long term (bonds mature in 10-20 years). Each type of bond will respond slightly different to changing of interest rates.

Currency risk is based on foreign investments. Some investors exchange US dollars for other currencies (like swiss francs, the euro or possibly the japanease yen). If you buy $1000 of something from japan for example (a stock or bond), there is the risk that even if the investment went up in japanease currency, the exchange rate might change, and actually have you lose money.

The way to deal with currency risk is 3 fold:
1) own more foreign bonds or foreign stocks from many different countries and regions- do not focus only on Europe or only on Japan
2) focus most international investing in established countries (France, Spain and England have more established economies than Russia, Vietnam or Bosnia).
3) do not put all of your porfolio into foreign investments, so only a portion of your porfolio has currency risk as part of the risk profile.

Investment risk
This is the risk that you invest in something, and something else has a higher return for the same amount of risk taken.

The way to deal with this risk is two fold
1) track performance of your investments, so you know how good or bad your performance is, then compare your own performance to similar investments you do not own.
2) Divide your investments among many different categories. Domestic stocks, foreign stocks... domestic bonds, foreign bonds, large companies, small companies, real estate and commodities.

How you divide the assets up is less important than just making sure you own some of the most popular types of investments (own some stocks, some bonds, some domestic, some foreign).

Geo-political risk-
This is risk that you buy foreign investments, and the country you invest in has their economy overturned by revolt or war. For example investing in Iran, Iraq or other middle eastern countries carries this risk more than buying a stock from a canadian company for example.

Information risk-
This is the risk that you do not have all the information needed to make a decision. Could be education on your part, could be that you are a more passive person and do not wish to spend countless hours every week, month or year tracking various economic information.

If you want a passive investment approach, look for good passive investments. Might be index funds, target date retirement funds, or couch potato portfolios which tell you what to buy.

Sector risk- this is the risk you overweight a specific sector, and that decision negative impacts performance because either
a) that sector did really bad
b) another sector you did not include did really really well.

Sector is the term used to describe companies which are similar- health care companies, energy companies, real estate companies, financial companies, technology companies, emerging markets, and more.

You can use a tool like morning star xray to example specific mutual funds and get an idea of what sectors you are invested in.

If you use managed mutual funds, it is very likely what the fund manager is trying to do will be to overweight one sector or another to gain an edge on the market. If you use indexed mutual funds, more than likely the index is divided into most sectors of importance. You should still check, but most popular indexed (Wilshire 5000 and S&P 500) are diversified into most sectors.

Liquidity risk- Liquidity means the ability to sell something quickly and get money for it.

A house is not liquid, a stock is kind of liquid, and money in a savings account is completely liquid.

If you know you need money soon, it is best to put it in liquid investments. If you know you have to pay for your kids education in 5 years, you want most of the 1st year's tuition in a liquid investment so you have access to 100% of the money you need for that expense.

Inflation risk- inflation is how investors measure the increase in prices. If you buy a car for $20,000 today, and that same car costs $25,000 next year, the $5000 price increase is considered inflation.

The most important aspect of inflation risk is that the longer term you need the money (like for retirement), the more likely inflation risk is among the biggest risks you have. For short term financial goals (like buying a house in 2 years) the less inflation plays a part in the costs for the item. If you were buying a house in 2 years, the cost of the house would be more subject to market pressures, suppliers costs (cost of materials), labor costs variability and other (and not inflation).

The most common method to combat inflation risk is to invest in assets with a high historical average yearly return (stocks). Most other investments (bonds, real estate, commodities, cash) might have a higher 1 year return than stocks (sometimes), 5 year returns (happens once in a while), 10 year returns (happens very very rarely), but over 20 and 30 year time periods, stocks have a higher return than most other investments available to common investors. Higher return means it combats inflation risk the best.

---

Risk summary
No investment is risk free. If anyone tells you they have a risk free investment, run away from them as fast as you can.

Investing is about managing risks. There might be some risks I did not mention here unique to you... the best thing you can do is educate yourself on what each risk is and be comfortable with the amount of each risk you take.

Examples

Person A invests in the following:
80% stocks 5% bonds 15% cash

Person B invests in the following
80% stocks 15% bonds and 5% cash

Person C invest in the following
80% stocks and 20% bonds

What do we know about each of the above?
Person A has more liquidity- why?
Person C has the least liquidity- why?

Let's add some information to each person now...
Person A invests in the following:
80% stocks 5% bonds 15% cash

40% domestic large cap
10% domestic small cap
20% foreign large cap
10% foreign emerging markets
5% high yield bond
15% cash

Person B invests in the following
80% stocks 15% bonds and 5% cash

20% domestic large cap
20% domestic small cap
20% foreign large cap
20% foreign emerging markets
5% high yield bond
5% foreign bonds
5% domestic government bonds
5% cash

Person C invest in the following
80% stocks and 20% bonds

40% health care stocks
40% japanease stocks
20% emerging markets bonds

questions:
1) which person is taking on the most currency risk?
2) which person is taking on the least currency risk
3) which person is taking on the most interest rate risk?
4) Which person has the most sector risks?
5) which person here in your opinion is taking on the most risks and why?
6) which person in your opinion will have the highest return

Hopefully 5 and 6 are the same person- if you take on more risks, you expect to have a higher return.

**Beppington** · 01-07-2010, 11:01 AM

This reads like a class about financial risk rather than a test or questionnaire I can fill in that will spit back a definite answer about how much risk I should take on. Was that your goal?

**jIM_Ohio** · 01-07-2010, 11:46 AM

Most web sites have a questionaire which spits out a specific allocation for a given risk tolerance.

But that same questionaire does not fill you in as to what risks you are actually taking.

My goal was to educate on what the risks were, and how a given risk is accounted for.

A few things- I would prefer a questionaire not give specific advice (I am not recomending anyone go 40-60 or 80-20 or choose any specific mutual fund). So it is vague on purpose in that regard.

My goal is to have a place when someone posts "where do I start", I can link the thread in a post, possibly quote some text, and save myself retyping the same information over and over... I find many of my responses on this site to be similar, I just direct them to different people. So having a thread on what risks exist is helpful if a person thinks that investing is too risky.

Investment risk questionaire