It is so easy to buy an investment, especially with the advent of online Internet facilities. But it is in selling and selling at a profit that people will find most difficult.
It is so enticing to hear people talk about how they made money in financial securities and how easy it was done. In doing so, however, they gloss over one aspect that is inherent in all investing activities and that is the risk that they took.
Risk may be invisible, but it is still there. It is akin to the East and West Valley fault lines in our country. We don’t actually see them; yet they are clear and present danger to those near them.
So how does risk figure into investing? Risk simply represents the chance that an investor may not earn his target return. Risk can also represent the chance of losing part or all of an investor’s capital.
There are two types of risk: unsystematic and systematic. Unsystematic risk refers to that type of risk whose impact can be minimized. For example, credit default risk refers to the likelihood that a bond issuer will not be able to repay the interest and principal on its debt. The question is why anyone will want to hold on to a bond with a significant credit risk. The answer is that high risk also means potential high return. A bond with a significant credit risk will also be paying out a relatively high interest rate.
To minimize the credit risk, an investor may want to mix bonds with low credit risk into his portfolio. To keep credit risk to as low a level as possible, an investor may alternatively just limit his bond investments to bonds with the highest credit ratings. Ratings of bonds issued by Philippine corporations may be secured from the Philippine Rating Services Corporation or Philratings (www.philratings.com).
Systematic risk, on the other hand, refers to risk that cannot be minimized or done away with. For example, when interest rates shoot up, most businesses are affected. Companies will find it expensive to service their borrowings. As a result, banks will have a higher percentage of their borrowers delaying payments or even defaulting on their loans. Bond holders will see a drop in the price of their investments (i.e. when interest rates go up, the value of bonds go down and vice versa).
An investor should try to minimize the unsystematic risk in his portfolio so that what is left is the systematic risk. And the best way to do this is through what is called diversification. Diversification can be had by simply following the proverbial rule of not putting all of one’s eggs in one basket.
In practical terms, an investor can spread his investments among different asset sectors within an industry, different industries, different asset classes (e.g. stock, bonds, money market), several currencies, and even among several countries.
Whatever the strategy, the investor should always remember that risk is a clear and present danger that goes with returns. Ignoring it will be as foolish as building a house on a fault line.
Next up, we will try to measure risk.
(Originally written by Efren Ll. Cruz, RFP at http://www.savingstips.com.ph)
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