Risk Management 101 📉
The concept of ‘risk management’ isn’t something that’s top of mind for the average DIY investor, who typically focuses on making their money grow rather than protecting it. We’re going to take a look at three risks faced by DIY investors and how to manage them.
Risk specific to a single company or industry
When invested in a single listed company share or a few shares within one industry (like Oil & Gas, Consumer Goods or Financials), investors face the risk of losing money because of something happening to that specific company (like fraud) or the industry overall (like a change in regulation that negatively impacts the industry).
This risk is managed through diversification. This means spreading your investments over different assets, where the price or value of these assets don’t move together. This is another way of saying ‘don’t put all your eggs in one basket’! Investing in 5 shares that belong to the same industry is like having 5 eggs in the same basket. Spreading these eggs over 5 different baskets will reduce the risk of all 5 performing poorly at the same time, however all 5 eggs are still in ‘equity baskets’. Looking to other investment types will add further diversification.
Losing purchasing power
Inflation is the general rise of prices over time and is generally measured by the Consumer Price Inflation index (or CPI). Inflation risk, or ‘purchasing power risk’ is the risk of not being able to buy that same amount of stuff with your money in the future as you can today. This happens when our investment growth doesn’t keep up with inflation and the prices of goods grow more than our money does.
By not investing at all (think “cash kept under the mattress”), we lose the most purchasing power. Keeping money in the bank will provide some growth but is unlikely to be more than inflation.
This risk is managed by investing in various types of assets that are likely to grow faster than the rate of inflation. These include investments that provide capital growth (where the asset itself can increase in value over time), not just income — like shares and real estate.
Losing your job or ability to earn
Losing a job may leave you without funds to live off while looking for another job. This is where emergency savings in the form of quickly accessible cash is important. Having all your money tied up in your investment portfolio will mean having to sell and withdraw to get cash and this may be at a bad time. Having your emergency funds tied up in long notice or call deposits isn’t great either, as you may face penalties trying to get early access.
The worst case is getting injured or facing a disease that leaves you unable to perform your job or any other job, and therefore without any income. This is arguably the biggest risk faced by any person. This risk is mitigated by having the appropriate ‘income protection’ or ‘disability’ cover in place. This is an insurance policy that aims to replace some or all of your income or provide you with a cash lump sum — allowing you to support yourself until a certain age. For many permanently employed people, this ‘risk cover’ will be provided as part of an arrangement with your employer. If you’re unsure, now’s the time to get the details so you know if and for what you’re covered.
While wanting your money to grow is the main aim, make sure you understand the risks you’re taking on and if this makes sense. Aim to do better than inflation to protect your purchasing power and mitigate risks where you can.