The ability to evaluate risk – an essential skill for all investors

 

ABN AMRO headquarters in Amsterdam.

ABN AMRO headquarters in Amsterdam. (Photo credit: Wikipedia)

Perhaps the most useful character attribute for an investor is a healthy scepticism. The investment world is made up of providers, and consumers. Looked at in a less charitable way, there are the exploiters, and the exploited.

There must of course be profit for both. What the consumer wants, and has a right to expect, is an adviser who will put client interests before their own. The consumer must pass a judgement on the integrity of their adviser, as they have no way of knowing in advance whether the adviser is simply going to make money at their expense.

Why not be upfront and ask your adviser how they are going to screw you? If you prefer a less crude approach, ask what is in it for them. How they answer such a question may be quite revealing of their good nature, and honesty. You should be made aware of all charges and expenses, preferably in writing.

Risk assessment is a practical step in investment decision-making, not just an academic exercise. Risk is universal and risk assessment just a prelude to the ongoing need to manage risk. Risk is linked with reward. Is the potential return worth added risk?

You must not, if you wish to be successful, just accept the appraisal of others, no matter how expert they may seem. Unfortunately even the élite can be corrupted. The Standard & Poor’s rating agency with a tradition dating to 1860 has to accept at least partial responsibility for the global financial crisis.

The Standard and Poor’s Story

They yielded to commercial pressure from the global investment bank, ABN Amro and allocated AAA ratings to untested complex derivative products known as Collateralised Debt Obligations (CDO) and Constant Proportion Debt Obligations (CPDO) designed to generate profits for the bank, and transfer the risk of inherently risky US home loans to gullible clients.

Thirteen Australian councils lost A$16 million when Lehman Bros bank collapsed and these exotic investment products proved valueless. A total of 72 Australian councils and community organisations lost collectively $200 million, money from the pockets of ordinary Australians.

Although these institutions were never clients of Standard & Poor’s, because they had trusted the S&P rating, they were able to successfully sue them for the money they had lost. They really should have known better. Commonsense could have warned their treasury officers that the risk was high. Derivative products have no inherent value. Their value resides in the primary security, as does the risk. Further there was no track record of profitability to guide in the assessment of the reward side of the equation. Not surprisingly ABN Amro earned hefty commissions, and are still prospering.

Retail investors in similar situations are unlikely to have recourse to the law for recompense, and will simply lose their savings.

Some Risk categories

It is helpful to have in mind a check list of risks to consider. They are inter-related but for ease of recall can be considered under the following headings:

  • Provider/Adviser risk.
  • Inherent risk, according to the type of investment product
  • Regulatory risk from adverse political decisions.
  • Trading risk from lack of capital and inadequate liquidity, creditworthiness of customers, economic downturn, cyclical factors, competition.
  • Management risk. Poor decision-making, executive greed, and fraud, poor corporate culture, and disharmony, failed business models.
  • Income risk from adverse interest rate changes, currency exchange risk, natural disasters, and industrial actions
  • Risk from your own lack of focus, and poor decisions.

Risks are known or unknowable. Some risks may be prevented with wise choices; others can only be managed or hedged against. If you are uncertain what decisions to make, get a second opinion, or seek specialist advice. If you think you are being unfairly treated, send a complaint to the appropriate regulatory authority.



Categories: Community Issues, Superannuation

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