Welcome to a new week and newsletter.
As those of us in Nigeria grapple with the ongoing #EndSARS protests and the implications for residents,(as far as interaction with the police is concerned), we will be discussing another reality many investors, irrespective of location are yet to fully deal with and this is the fact that every investment has its own inherent risk.
According to Investopedia, financial risk can be described as the chance that the outcome or an investment’s actual gains will differ from an expected outcome or return.
This risk includes the probability of losing not only the expected gain but some or all of the principal amount invested.
Even though the risk related to various investment vehicles can be managed effectively, it does not eliminate its existence and this has proven to be a bridge too far for some investors to cross. This mindset whilst understandable, is counterproductive as financial gain can only come through investing.
However, there is a class of investment – that is deemed riskless and that is government backed securities (bonds and treasury bills), simply because the returns are known with certainty and there is little or no risk of default. These investments typically have low interest rates and as such are exposed to inflation risk – a scenario that is currently playing out in the Nigerian fixed income market.
Please bear in mind that it is the US Treasury bill that is used as the basis of this definition and in reality, some governments have been known to default on their obligations. Argentina readily comes to mind as well as the recent move by the Zambian government to defer its Eurobond obligations till next year (last week, its bond holders rejected this proposition).
There are 2 types of financial risks – market (systematic) and specific (unsystematic) risks.
- Market/Systematic risks: are risks that affect either a large portion or the entire market. The pandemic and its impact on global tourism is a perfect example of this. In addition, currency and country risks are also types of market risks.
Hotels and airlines are amongst those that have been affected the most. Share/Stakeholders in these companies are not expecting positive returns on their investments this year or anytime soon. Examples abound on how many of the players have had to pivot in order to survive.
Although country risk refers to the likelihood of a country defaulting on its financial obligations, it can also be used to describe the uncertainty inherent with investing within a particular country (Investopidia).
The ban on the commercial motorcycle operations that initially affected companies like Gokada and O’ride is an example of country risk.
- Specific/Unsystematic risks: these are risks that affect either a specific industry or company. The N330 million SIM registration fine imposed on MTN Nigeria in 2015 is an example of a specific risk.
Whilst you can mitigate against specific risks through portfolio diversification, the same cannot be said about market risk.
Although portfolio diversification does not eliminate financial risk, it is still the most effective manner for reducing it.
Portfolio diversification is a method of allocating investments in such a manner that reduces or limits one’s exposure to any particular asset.
Below are some steps for portfolio diversification:
- Ensure that your portfolio is not concentrated to only a few investment types but several – cash, shares, real estate, fixed income, mutual funds etc.
- Further ensure that there is diversification within each investment type. For example your share portfolio should include several blue chip companies and not just 1 or 2 companies.
- Regularly monitor your portfolio to prevent a skewed position. Kindly refer to our story on the founder of Zara who earlier in the year reallocated funds from his share portfolio into real estate in the face of declining share prices.
In conclusion, it is important to remember that everything in life comes with its own risk and investing is not any different.
Also note that “When a child learns to walk and falls down 50 times, he never thinks to himself “maybe this isn’t for me”.
We cannot eliminate risk but can manage it effectively by finding the right balance between our risk tolerance and expected yield.
Kindly remember that there is still no cure for the corona virus and that prevention is always the better option.
Please stay safe and continue to take personal responsibility for ensuring that Nigeria does not experience a second wave of COVID 19.
Keep washing your hands, maintaining social distancing and wearing your face masks in public.
Till next week, do have a wonderful week.