Sunday 19th December, 2004

 

Stock market risk

 
 
 
 
 
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Money Matters
with Raziah Ahmed

There is a new wave of thinking in business literature: the so-called “soft edge.” It is a philosophy, that creative thinking is the essential competence that fuels sustainability. It purports that the tried and tested ways, are a positive template, but by themselves, may not hold court in the innovation revolution. Systems that are fundamentally uncreative, and hard line, are dying. This is equally applicable to our perspectives on managing our money.

Last week, we looked at aspects of property risk, and how risk can be transferred, or else self-managed. Today, we will examine some of the concepts in the new wave of investment thinking: stock market risk.

The risk that we will outlive our savings is greater now than ever before, the risk of inflation, or devaluation (the US dollar has lost another 10 per cent against the euro), is old news.

The depletion of our natural reserves is a factor within the context of an economic theory based in “scarcity.” With the advent of the Unit Trust Corporation, the local community began to dabble in mutual funds. Prior to that investment, was limited to banks and insurance. Since then we have developed a local stock market, and investment brokerage firms.

Speculative risk

What determines whether you participate in these new investment opportunities is something the brokers call “risk tolerance.”

This is your ability to shoulder the loss in speculative risk taking. Recall that speculative risk is that category of risk characterised by an opportunity to gain, coupled with an opportunity to lose. There are questionnaires that help you determine how “risk averse” you are ie how well you can tolerate a loss if the market plays the wrong way. There are well-touted stories of people shooting up Federal buildings in the US because they lost thousands of dollars on the stock market.

After you have gauged your risk tolerance, the next phase is to stabilise your investment portfolio. This you will do via secure investments, such as bank and insurance investments. These form the foundation of risk management. Without them, your portfolio is without the two feet upon which every portfolio must stand.

Next, you can examine the playoff between return and risk. The rule of thumb is that the greater the promises of gain or return on investment, the greater the risk of loss. There are four major vehicles to contemplate: mutual funds, bonds, stocks or equity, and commodities, each with a successively higher risk and promise of return.

Mutual funds carry the least risk, of the four, primarily because they are managed by “fund managers” who bring an independent perspective on the performance of the companies involved. In this market, fund managers buy up a variety of stock and/or bonds in organisations.

Intelligent guesswork

The companies are studied, in terms of past profits, and projections for the future of the business. Intelligent guesswork, using fancy equations, is involved in trying to predict a windfall.

The purchaser of a “bond” really lends money. The contractual arrangement is that the bondholder “lends” his/her money to the issuer of the bond, typically, in exchange for a monthly/ quarterly income, and a return of the money loaned, at the end of the life of the bond—usually a period of years. However, clauses in this type of contract are very crucial.

Recently, on the local market, a bond was “recalled.” This meant that the issuer of the bond had decided that it would not be able to pay the income that was promised!

There are creative ways to solve financial problems, resulting in win-win situations.

We shall continue our discussion next week.

n Raziah Ahmed is a Registered Financial Consultant.

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