Issue: 38
Sent: 15-05-2006 08:48:42
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So what is risk? - Lester Wills
Last year Macquarie produced a booklet on understanding risk, where it listed 9 different types of risk, namely:
Mismatch Risk:
Where the investor may choose investments that are unsuited to their needs and circumstances.
Inflation risk:
Where the return earned does not keep up with inflation.
Interest rate risk:
Where movements in interest rates may have a deleterious effect on the return earned.
Market risk:
Relating to movements in the markets affecting the return earned.
Market timing risk:
The risks involved in trying to time the market.
Diversification risk:
As in the risk involved in not diversifying.
Liquidity risk:
The risk involved in potentially limited access to money.
Credit risk:
The risk that the institution where the money is "invested" is not able to make "promised" interest rate payments.
Legislative risk:
Referring to investment strategies being affected by changes in the law.
The booklet does not mention several other types of risk, including scam risk, which is discussed above.
Michael Roszkowski from Salle University in Philadelphia suggests that if you have never experienced a certain event, far too often you will assume the probability of it happening is zero.
Callan & Johnson, from University of Queensland Business School argue that risk tolerance is an attitude that is made up of a balance of different components. It is the degree to which a client is willing and able to accept the possibility of uncertain outcomes being associated with their financial decisions
Kathleen Gurney talks of risk as being a subjective or personally experienced emotional state influenced by the ability to make decisions under conditions of uncertainty. She argues that it contains important subjective elements not typically considered or evaluated by the investment community.
It is the subjective risk of investors, which will determine perceptions, reactions, satisfaction, suitability. Dr Gurney goes on to suggest that if investors subjective definitions of risk don't enable them to sustain their strategies when they make rational sense, then they will create their own financial loss in selling impulsively.
Risk tolerance is a complex issue that involves much emotion. Studies have shown that people are twice as sensitive to losses as equivalent gains. I would also argue that when risk involves non tangible assets (such as shares as opposed to bricks and mortar), the attitude will change as well.
People simply do not appreciate the risks they are taking when they are investing in real estate. It is something they can see and touch and therefore is tangible. But investors are likely to be at best more concerned and at worst less tolerant of an equivalent investment in the stock market. Even if it has the same level of risk over the same time period.
Such an approach is not exactly rational but appears to be human nature.
There are those who cannot see that real estate involves risk at all. They are probably from the same school who believes that putting money in the bank is a risk free investment. I often use one word to describe this approach; it is a description of something that emerges from the rear end of male bovines.
In such an "investment" people are quite simply running the risk of not having enough. This is inexorably linked to one fundamental risk that thus far has not been mentioned.
Longevity risk, namely outliving your money.
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