Risk – Financial.

What is risk in a financial sense? For a technical definition there are many sources you can use such as Investopedia. https://www.investopedia.com/terms/r/risk.asp

Type of Risk.

Sovereign Risk.

It wasn’t that long ago that Australia had a very low sovereign risk, however over the last decade that risk has been slowly growing.

Some might say that sovereign risk has increased as our international debt has increased, however it is more the fundamentals of the economy that have lead to the increase in sovereign risk.

Australia has relied on its exports to create wealth. These exports are primarily iron ore, coal, minerals, agricultural products. Of recent times those have been joined by education and tourism. Without these exports the Australian economy descends into bankruptcy.

Not only are we dependant on a few exports but we also have limited markets, with the largest being China. Australia has been here before with Japan in the last 1980’s, a downturn threw us into the depression of the early 1990’s. 

In the late 1980’s Japan had a huge trade surplus that was fuelling its growth. On April 18 1987 President Ronald Reagan put a 100% tariff on many Japanese products. The results of that were that Japan ‘s trade surplus stopped, killing its growth that never recovered. The Japanese slow down reduced Australia’s exports of iron ore and coal to Japan driving Australia into a deep recession.

Move to the present. President Trump is treating our largest trading partner the same way as Ronald Reagan did. China’s growth was slowing anyway as its internal consumption increased as a function of its growth and productivity increases.

COVID-19 has killed off international education and tourism.

Political influence, green tape and lawfare has resulted in the halting of $65bill in capital expenditure.

The failed Murray Darling water system has reduced our capacity for agricultural production.

A failed IR system has killed prospects of a growth in new business. Australia’s growth in new business is the lowest since the days of Gough Whitlam in the 1970’s.

The governments predilection towards international wokeness, especially in regard to CO₂ emissions has guaranteed our inability to produce enough efficient and sustainable electricity.

Forex Risk.

Australia represents about 2% of the world’s economy. The share market represents about 1.7% of the world markets. This mean that the Australian dollar is effectively a bit of a play thing for some of the major players in the world.

The exchange rate was thought to be a function of interest rate differentials between currencies the reality is that the $A is tied to the price of iron ore and coal. To boost the value of the $A the RBA has maintained interest rates well above those of are trading partners, however when the price of our exports dive so does our dollar.

It is relatively easy for our major trading partners to manipulate the value of the $A, this increases the risk considerably.

Systemic Risk.

The first half of calendar year 2020 has been a great example of systemic risk. It shows that at anytime there can be a black swan event that severely increases risk. While is this case the system risk was worldwide there are many cases when there are systemic risks associated in a single geographical area or an industry. 

In early 2020 both Cricket Australia and the NRL ran not insignificant systemic risk issues.

Non-Systemic Risk.

At the turn of the century I did a review of the ASX 100 and found that there was hardly a company that was not vulnerable to a major non-systemic risk. The same can be said today. While it doesn’t look like any of the FAANG’s are about to get knocked off their perch, it didn’t look like Telstra would be knocked off it’s perch in 1999 when it was trading at 3 times what it is now and paying a dividend 4 times the present one.

Shopping centres were all the go a few years ago and now they can’t get tenants. It only takes a poor government policy to send a company or an industry out of business. Minority activism can target anybody or anything with destructive results. 

Russia and Iran had a blue and the oil price crashed. 

Interest Rate Risk.

Interest rates effect risk in several ways. There is the forex question but more importantly there is the question in relation to loans and gearing. You can get loans with se interest rates but you pay more for them, effectively an insurance policy.

Liquidity Risk.

We all now that property is a lot less liquid than equities, but few people look into liquidity within the sphere of equities. I recently had a young man ask me about a certain company he had done a lot of research on. All the figures looked good until we looked at liquidity. Recently it had gone for 4 days of trading without a single sale. Small companies can buy into small caps but then liquidity is compromised at both ends.

In early 2020 the major Industry Super Funds ran into significant issues with liquidity

Contractual Risk.

Its great to have a contract, but what if there is a default. An issue that is being investigated at the moment is that for a small builder to build a residential house they need to spend about $45,000 on red tape issues before they begin building. They are only able to bill the client $5,000. That means anybody can get a builder to start a project and then bail out for financial reasons only losing $5,000 while the builder loses $40,000

If you are looking to get into a small building development you will find a few on the market where a builder is selling the land and all the approvals, these deals are often the result of contracts that have gone horribly wrong.

Risk and Reward.

The theory is the bigger the risk the greater the reward. In the case of public servants they have far less risk and a much greater reward, that story is best left for the inefficiencies of the market system when institutions get involved. But the point is that greater risk doesn’t always bring greater rewards.

Diversification Mitigating Risk.

A lot of risk can be mitigated through the diversification of assets.

Geographical.

At present the world has two global hegemons battling it out, who is going to win? At the same time you have Japan that has stalled for three decades, Europe that is blowing apart, India that has just got on the roundabout, and Australia that continues to shoot itself in the foot. Are you going to pick a winner or have a few bets each way?

Investment Vehicle. 

We have cash in any number of forms.

Property either directly or indirectly through EFT’s or REIT’s.

Equities as individual investments, LIC’s, EFT’s, Private equity trusts, or managed funds. 

Many of these have differing systemic risks to the overall market, others just lower the overall risk. 

You could add here your own personal investment vehicle. 

Personal, Company, Trust, managed Super Fund, SMSF. All have advantages and disadvantages.

Industry Sector.

It is not just the industry sectors anymore but sectors of the sector. For example during the COVID-19 pandemic some micro-sectors of the health industry did very well and others did very poorly. 

Superimposed on sectors these days are the Ethical Investments that have done so well in recent times. The question to ask is have they done well financially or are they over valued because woke consumers have been buying them.

Any sector is vulnerable to political, cultural and economic risk, and that is why it is so important to understand the environment in which you are investing.

Market Capitalisation.

In some ways this is a subset of liquidity, is others it is more than that. 

When a business is started it goes through a few stages.

1. The entrepreneurial start up.
2. Business Angels.
3. Private equity.
4. IPO. 
   1. Micro Cap.
   2. Small Cap
   3. Mid Cap.
   4. Large Cap

Each step has its own problems and risks, and the curve is not a straight line. The risks moving to IPO are sometimes much greater than you think, especially in this country.

You need to understand that the Australian system is skewed against the smaller companies. Larger companies thrive on regulation and political lobbying. The large caps have the time and money to throw around their weight and reduce competition by increasing the barriers to entry for the smaller companies.

Time Horizon.

Understanding ourselves is an important part of the investment process. Decisions will be guided by our values. Our appetite for risk is a fundamental belief in governing our behaviour. You need to realise that your appetite for risk will change as you move through life.

When you are a footloose and fancy free graduate you will have a much higher appetite for risk than when you are a new parent.  Risk then abates as your partner gets back into the workforce when the kids go to school and you are paying don the mortgage. Then the kids get more expensive as you approach retirement and the perceived risk level rises again.

Major Investments. Time Horizon.

1. House. Saving 6 – 10 years.
2. Kids’ education. Saving 5 – 18 years
3. Retirement. Saving 45 years.

Not only will your intrinsic risk profile change as you change through time, but the risk profile of each investment will change.

If you are saving for a house you don’t want to invest in a 10 year time line as you will probably want to house earlier than that. On the other hand investing in a 10 to 20 year project in your superannuation is not an issue as a 30 year old. That is different a you approach retirement age.

You need to be aware of the purpose of the investment and the time horizon of the objective.