You might be worried about locked up funds, may be a financial institution you invested in closed down or yet still the caretaker of your side business bolted with your money. If you are anxious about these and more, then I invite you to read on. You will know why it is that funds get locked up and how to make money in future without locking up your funds
You might have heard that Government bonds are considered risk-free, bank fixed deposits are low risk while stocks and real estate are high risk. At the end of this article, you may be able to judge for yourself if there are risk-free investments.
So, what exactly is risk?
It will surprise new investors that there is more than one definition of the concept of risk, and frustrating for many to discover that risk is often not quantified precisely. We shall discuss how finance professionals have tried to measure risks another day.
For purposes of this article, define is risk defined as the possibility that you may not get back some or all of the money you expect from an investment. It includes the chance that you may lose some or all of your original principal. This risk of loss is increased if the investor lacks sufficient knowledge and capacity to identify from where risks are likely to pop up and attack his or her investments. Let me state that when an investment promises high returns, it implicitly means high risk.
Where do risks come from?
It depends on whether one invests in financial or non-financial assets. Click here to read about financial and non-financial assets. Some of the risks are systemic and thus affect everyone in the economy while others are specific to the kind of investment you are holding.
If you invest in bonds, stocks, personal pension plans, mutual funds, currency, fixed deposits etc., below are some of the sources of risk and how they affect your investments.
I. Inflation Risk
Inflation reduces the purchasing power of your money. If your investments do not return above inflation, in the long term you will lose your economic position. For example, if inflation rate is 10%, it means in a year’s time, the money you have can buy 10% less than what you can buy with it now. As a systemic risk, inflation risk affects all investments whether government bonds or equities. The return above inflation rate is called the real return. For you to be making any meaningful progress towards your financial goals, you should aim to make positive real returns.
II. Interest Rate Risk
If interest rates rise, the value of your bonds will fall below principal if you try to sell on the secondary market. Its value will rise if interest rates fall. Let’s say you purchased 2-year treasury note at 19% for GHS50,000. Six months later, government is issuing new bonds at 21% and you are stuck with 19% bonds. When you want to sell your 19% bond for whatever reason, you will sell the bond for less than GHS50,000 for anyone one to be willing to buy your bond, if not they will abandon your19% bond and buy a fresh one at 21%.
This risk affects bond investors more directly than investors on the stock exchange. Anytime you make any investment that involves receiving principal and interest repayment in future, know that the chance you will gain or lose some will depend on future interest rate movements, and no one can predict whether in future interest rates will move up or down.
There is another related risk caused by interest rate movement called Reinvestment Risk. For example, you invest for 3 years at 26% pa. You may find that if you want to roll over at maturity, you can only do so at 18%, losing the opportunity to earn the higher returns.
III. Default Risk
This is the risk that the issuer (government or private company) may not be able to pay the interest and or principal to the investor(s) due to financial difficulty. Often, when you hear government treasuries are risk free, they mean government will not default (default risk free). When you are tempted to believe this, just remember Greece, even Ghana has defaulted twice in our history as a nation, the last default happened in 1982.
Ghanaian investors have had to grapple with massive default risk from placements with non-bank financial institutions (NBFIs) and pyramid like schemes. Some corporate bonds issuers have also defaulted on their principal and interest payments.
IV. Liquidity Risk
A security which can be easily sold without need to significantly reduce price is considered liquid. Some investments take a long time to sell and you if want to sell quickly, you will need to reduce the price significantly e.g. real estate, equities in Ghana and non-financial assets like piggery, farm, car washing bay etc. Those investments are illiquid and so have higher liquidity risk.
Treasury bills and bonds have a ready market in Ghana and have lower liquidity risk. I know some countries where private placements are more liquid than buying government treasuries, bizarre isn’t it?
What should new investors do about risk?
Do not run. Being aware of your sources of investment risk and deciding how much loss it can bring should help you take some steps to minimize their likelihood and impact. So, I can infer that the real risk resides in an investor being either unaware of risk and/or not knowing the appropriate actions to take to minimize their impact.
Having followed me till now, do you agree that governments are “risk-free”? In future articles, we will tackle risk mitigation and risks of investing in non-financial assets as well as how to protect yourself from those risks.