Friday, May 27 2022

WHEN they said this month would be a red October, they didn’t realize the stock market would literally be in deep red. Filipinos are generally conservative and yet surprisingly in recent years I keep hearing how many people have put their hard earned money into stocks. Although stocks as an investment can offer a potentially good return, the risk component of such an investment should be considered. At present, most, if not all, of those currently invested are now suffering heavy losses.

So if it’s not stocks, I’ve always been asked what investment I recommend best that will give a good return without taking any risk. Well, the bad news is that this type of investment does not exist. Even your user-friendly and safe term deposit or savings account is not completely risk-free.

Risk is the possibility that the actual outcome will differ from what is expected. Two investments, A and B, giving an average of 8% may look identical, but on closer examination, in investment A one can potentially lose up to 20% and gain up to 30%, while B provides a constant percentage of 8% per year. I’m sure with this additional information, one will most likely choose investment B.

You are probably told that to eliminate this risk, you have to diversify and better yet, let a professional manage your investments. Unfortunately, this is only partially true. No matter how you price your investment and no matter how much you diversify it, you can never eliminate risk. To better understand, there are two types of risks associated with your investment (as an investment or as a complete portfolio). One (unsystematic risk) can be diversified, and the other (systematic risk) cannot.

Unsystematic risk

This can be diversified. This type of risk is very specific to the asset you purchased (company specific).

Say, for example, you invested in Company X and there was a mass recall of a product made by that company because they discovered it was contaminated with poison. Or say the company got into a stalemate with its union, or even as simple as a warehouse catching fire. This business will be at great financial risk. The financial risk will also be high if the company has a high level of debt. Another example would be if your investments are overexposed to one or very few sectors or asset classes. This may be the case if all of your investments are only invested in Philippine stocks.

The good news is that you can eliminate this risk by simply adding different investments and different categories of investments. An asset class is a group of securities that exhibit similar characteristics and behavior in the market. The three most common asset classes are stocks, fixed income securities or bonds, and cash equivalents or money market instruments. This includes your friendly time deposits and savings accounts. More sophisticated asset classes would be real estate, commodities, and lately, cryptocurrencies such as Bitcoin. This risk can be reduced because the other assets in your portfolio can offset the unsystematic risk associated with this asset. If set up incorrectly, you can still end up with high unsystematic risk, whereas a well-planned portfolio will eliminate that risk.

Systematic risk

This risk cannot be eliminated or diversified. This risk is linked to the market compared to the first which is specific to the company. Market risks can be macroeconomic variables. Examples of these macroeconomic forces are unexpected changes in the country’s growth rate like gross domestic product and gross national product, consumer price index, industrial production, interest rates, exchange rate or even the money supply. In such cases, your whole portfolio will be affected. While one asset may be more affected than another, overall there is no way an investment can escape the impact.

A good example would be the recent rise in inflation to 6.7%. Inflation is the rate at which the general price level of goods and services increases and, therefore, purchasing power decreases. This is why it is generally referred to as purchasing power risk. Unless you live in the Philippines, it is certain that every Juan de la Cruz, no matter their social status or the size of their wallet, will be affected.

The combination of unsystematic and systematic risks constitutes the total risk of your portfolio. As mentioned earlier, unsystematic risk can be diversified and removed. So, if done right, what will remain is always the systematic risk.

So the next time someone tells you that the investment they are offering is a sure thing, you might want to think twice!

Happy rich life!

Melvin Esteban is a Registered Financial Planner of RFP Philippines. To learn more about personal financial planning, attend the 96th RFP in May 2022. To inquire, email [email protected] or text at 0917-6248110.

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