Understanding Risk

Investment Risks

There are many different types of risks of securities investments, the worst being that the company goes bankrupt and cannot pay on its bond debts or the shares become ‘penny stocks’ or worthless.

Buying a number of bonds or a number of shares from different companies – ‘diversification’ – is the best way to manage this absolute risk. VCBF as the fund manager always reviews the company’s financials and monitors for deterioration in the asset quality of the bonds and shares it buys.

Normally bonds and shares fluctuate less drastically, and diversification can also remove some of the individual bond and share prices’ volatility too. Diversification is one method to handle risks - the prospectus provides details of many different types of risks and of the ways in which these can be managed or controlled. There are broadly two categories.

Specific risks

Specific risks are those that affect one bond or share or those in a particularly industry, but not all securities at the same time. For instance, a record harvest in coffee will affect coffee producers’ profits and its share price, but not that of an air-conditioner producer. The, including how the company’s management handles such other risks are also specific, such as

Systematic risks

Systematic risks are those that affect many or all bonds or shares regardless of the issuer in varying degrees. An increase in interest rates will lower bond prices, but also impacts share prices as the companies have to pay more to service their bank credit.

It is important to be aware of each company’s exposure to various risks and also to see if by diversification or by other methods, whether some of the risk involved can be effectively avoided or mitigated. The fund manager is constantly reviewing market conditions, company balance sheets and also examining how well the companies’ management handle their business.

Asset classes

Although many different asset classes have evolved in securities, there are basically three different types: bonds, stocks and derivatives with very different risk profiles.

A share is title to the ownership of a company and a right to future dividends if and when distributed.

A bond is an obligation of the issuer to make future payments of interest and repay the principal on maturity. The company must pay its obligations (like bond payments) in priority to making payments of dividends, bonds are considered less risky than shares.

Derivatives are securities which are often derived from very specific titles to very specific assets. Futures and options, for instance, give the owner the specific rights to buy (or sell) a particular share, bond, or other asset at a fixed date (‘execution date’) at a fixed price in the future.

Since the price of derivatives can be very low in relation to the fixed price, their prices respond very dramatically if the underlying asset prices or market conditions change. The risk of derivatives is considered higher than bonds or shares.

The responsiveness of prices of an asset or asset class to market movements is called its ‘volatility’. Managing a portfolio of investments successfully means that the risk profiles of the assets as well as their volatility needs to be understood and monitored.

Cash and cash equivalents can be seen as a fourth asset class and some are securitised such as certificates of deposit. These are commonly seen as ‘safe’ assets as they are not exposed to the same range of risks as other assets. Fund managers will generally hold a portion of a fund’s assets in cash or cash equivalents to cover obligations or to invest in other assets when the opportunity arises. Cash and cash equivalents are, as most assets, exposed to inflation risk.

An equity portfolio normally has more risk than a bond portfolio, and cash and cash equivalents the least risk. Generally, the market requires that investment in asset classes with higher risks generate higher expected returns.

The risks and potential returns of an investment need to be considered when constructing a portfolio to meet your savings’ targets.

Review your investments periodically and consider whether your portfolio needs restructuring as your savings’ timelines or your risk tolerance levels change!

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