Behavioural finance has an increasingly central part in conversations about investment risk, since managing emotional responses plays a key role in maximising returns.
Let’s face it – roulette is an adrenalin rush. Going for the big win your payout is 35:1, making your odds less than 3%. So in one spin, with everything you have on the line, you can beat or lose against the house.
But like with most gambling games, it’s more about luck than skill.
Unlike gambling, however, investors focus on the latter. But smart investors balance risk with return because they understand this common principle: risk equals return. Yet what risk are they really taking?
Most investors account for the most common types of risk, such as interest rate risk, credit risk, inflation risk, liquidity risk, market risk, currency or exchange rate risk, political risk…and the list goes on.
But how about those risks that you don’t even realise you’re taking?
Based on a 2015 findaWEALTHMANAGER.com survey of 50 wealth managers on risk, we have consolidated and have highlighted 5 of the top risks most investors underestimate:
One of the first principles your finance professor will tell you is that you must diversify your risk in order to even out your returns in the long run. That’s sound advice. What is often omitted until you reach a more advanced level of finance is that many investments have a similar underlying asset, especially when you get into alternative investments such as options, swaps, and forwards. How does it make any sense to invest in Google when you already are investing in a blue chip tech fund? It doesn’t.
But now here is where it really gets tricky – how much should you invest in aggregate given your return expectations?
Key question – do you understand what diversification you are really taking?
Many investors fall into one of the following traps:
Just as bad as over-trading or over-reacting to market movements, negative news, or isolated events, is under-reacting to such things or not even bothering to make a conscious decision to not act. That’s the biggest sin any serious investor can make. You took the time invest, but won’t take the time to monitor and manage your investments.
Key question – do you have the time to manage your portfolio as regularly as required?
Trading is easy. Anyone with a bank account can trade. And many that do, usually don’t understand why they are not able to see the net returns that their initial estimates projected. Simple, it’s fees. They eat our gains. The more you trade, the more your gains are overturned. Whether you’re a DIY investor or an investor with a financial advisor, fees will chip away at all of those smart moves you made previously.
But here’s the rub…
You didn’t have to pay them. Or at least, not as high or as much. There are other ways to circumvent this. For example, institutional rates. Most investors don’t realise they are eligible for them. And that can make the difference between paying between 1.0-1.5% and 0.50-0.80%.
By the way, did you know that with investing for over 30 years paying 3% instead of 1% can halve your returns? It’s pretty amazing what that a couple percent can make.
Key question – Why overpay for the same service and for lower returns?
Death and taxes. The two universal truths that no one can escape. But in death, have you considered how long you will live? When you want to make those returns? Many investors overestimate this one simple variable – you’re not living forever. This type of risk usually impacts annuities and bonds that carry a fixed pay period.
No surprise then that most retirement plans and insurance policies carry annuities and some type of mix of debt and equity.
Your payback period, amount, and what’s to be left for your benefactors are all key questions that are mostly overlooked when looking at the net capital gains in your financial statement at the end of each period. Which also, point in fact, will affect how much you end up paying in taxes.
Key question – is your portfolio tax efficient?
In the end, how do you account for all of these risks? Any one of these could destroy your portfolio. And there is no simple, out of the box financial model that you can employ which will accurately account for all of the above. So you are committing the biggest sin of all by taking the most risky of all risks – Roulette Risk.
Now you’re not investing; you’re actually just gambling.
If you suspect you could be getting a better deal on price and performance, get a second opinion. Simply complete our short online smart tool to start the process of upgrading to your best-matched investment manager today.