Ways to mitigate your external risks

12 July 2013

Unless you are content to stay in cash - which itself is not without risk - you incur some degree of risk once you begin to invest your money.

The risk could range between fairly low - such as if you invest in Singapore government bonds - to very high. An example of a high-risk investment may be a concentrated investment in a single penny stock. Investing in overseas assets incurs a host of other risks such as currency and country risks.

The first step in ascertaining how much risk to take is to review your life circumstances, your level of savings and assets, and your goals. Your goals could include retirement, funding children's future tertiary education, or saving for your own property.

Consult a financial planner or adviser if you have one, preferably someone who puts your interests first, rather than meeting his or her sales target. An adviser is likely to be able to help you to discern the risks that are worth taking, versus risks that are unrewarding.

Here are some ways you can mitigate the myriad external risks of financial investments:

  • Do your homework. Familiarise yourself with the structure and key terms of a product. You should understand the roles of the key parties involved in the product, the types of risks, and the impact should those risks materialise. In structured products, for instance, country or region risk may not be immediately obvious particularly when they are linked to the jurisdiction of the counterparty, as discussed in the accompanying piece.
  • Loss tolerance. Think ahead on how losses would affect your financial objectives and plans. Do you have the resources to sustain short-term fluctuations or to bear a permanent loss? The latter has happened in the recent past to investors in credit-linked notes, which had to be unwound because the issuer and counterparty went bankrupt.
  • Diversify. Spreading your funds among various asset classes ensures - to a degree - that the assets are not exposed to the same risks, or do not respond to the risks in the same ways. In times of crisis, however, the benefits of diversification may be diluted by asset correlations' tendency to converge. That is, when crisis is acute, as it was in 2008, the ensuing market panic causes almost all asset classes to move in the same direction: down. But there is still arguably a benefit as more conservative and high-quality assets tend to be able to preserve their value in a downturn.
  • Watch your asset concentration. This relates to diversification. Sometimes, concentration risk may not be obvious. For example, you may be highly exposed to the finance sector through direct holdings, unit trusts' underlying investments, and through structured products.
  • Watch your leverage. Borrowing to invest may seem an attractive proposition at the current low interest rates. But be mindful that just as leverage can be rewarding, it also magnifies risks. The potential downside may in fact far outweigh the upside. You may have picked a sound stock, for instance, but at times of crisis and market panic, banks could suddenly withdraw the margin facilities due to the sudden drying up of liquidity. This could leave you scrambling to meet margin calls or forced to sell your position at an unfavourable price.
  • Look beyond the insurance wrapper. It is a mistake to assume that bundled insurance products such as whole life and endowments are not subject to risks such as market-related and forex risks. Insurers invest their life funds in a variety of asset classes, including offshore assets. Risks are cushioned through diversification and a typically long holding period. But market factors - such as low bond yields or an equity market crash - could still cause returns to fall. Lower returns, however, are typically not immediately evident to policyholders due to traditional insurance's smoothing mechanism. Still, bonus rates of bundled products could be cut in a poor year.

Source: btinvest

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