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Issue No.1

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Assessment of Risk

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Most people favor certainty rather than uncertainty. In the world of investments, there are winners and losers due to various uncertainties. Risk, a key concern for many investors can be rather distressing. Investing in financial markets which are so dynamic today involves tremendous amount of risk. What is risk? Very simply, risk is a danger of possible loss of capital. Professionals describe risk as deviation around the expected rate of return.

Investors are naturally risk-averse but they also normally want a higher rate of return. Higher returns normally come with higher risks (refer to diagram 1 and 2). Investors cannot have high returns with little risks. How much risk is tolerable? - that depends on how comfortable you are with risk. Can you weather a 10% stock correction? What will you do then? Panic and sell, hold tight, or buy bargains?

Diagram 1 Diagram 2




Risk is part and parcel of any investment and investors would only be fooling themselves if they think they can live in the investment world without risk. Fortunately, although risks cannot be totally avoided, it can be minimized or offset.

Professional investment managers use various proven techniques to reduce risk. Nevertheless, we will not go deeper into techniques on reducing risks in this discussion.

We live in a world of uncertainties where disasters can just strike anytime, a world where things we thought should never happen and will not affect us - does! Take for example the devaluation of the Ringgit and most other regional currencies triggered by the baht's devaluation back in the middle of the year.

Many of us would think that we are independent of currency risk provided we do not invest internationally (currency risk is the risk associated with changing exchange rates). The fact is that even if we do not invest in international markets, we still cannot avoid currency risk. In other words, none of us can entirely avoid risk. We have seen how currency problems have compounded stockmarket losses.

The currency crisis has affected everyone from all walks of life. A man on the street may be still skeptical. Try reason this - in Asia, once the fastest growing region in the world, many projects in the early 1990s were financed with low cost U.S. dollar loans. Most borrowings were largely žunhedgedÓ because Asean currencies were pegged or linked to the greenback at the time (hedging is a process for lessening or eliminating risk by taking market position against your original position). As a result of currency devaluation, repayments have become much more expensive. This provide burden on the economy - non-performing loans may rise resulting in more bankruptcies.

If the value of our currency falls, we naturally become poorer as many things that we purchase from other countries cost more. The Ringgit has depreciated by 30% since the start of the crisis meaning that the locals have lost 30% of purchasing power. Imports become less affordable and foreign vacations become less attractive.

Currency risk has become even more critical for investors who invest in international markets. Foreign investment holdings may change in value as the currency value changes. A return of 20% may shrink to a single-digit return after taking account for currency loss. It could even translates to a net loss position.

Risk is part and parcel of any investment and investors would only be fooling themselves if they think they can live in the investment world without risk. Fortunately, although risks cannot be totally avoided, it can be minimized or offset.

Professional investment managers use various proven techniques to reduce risk. Nevertheless, we will not go deeper into techniques on reducing risks in this discussion.

We live in a world of uncertainties where disasters can just strike anytime, a world where things we thought should never happen and will not affect us - does! Take for example the devaluation of the Ringgit and most other regional currencies triggered by the bahtŪs devaluation back in the middle of the year.

Many of us would think that we are independent of currency risk provided we do not invest internationally (currency risk is the risk associated with changing exchange rates). The fact is that even if we do not invest in international markets, we still cannot avoid currency risk. In other words, none of us can entirely avoid risk. We have seen how currency problems have compounded stockmarket losses.

The currency crisis has affected everyone from all walks of life. A man on the street may be still skeptical. Try reason this - in Asia, once the fastest growing region in the world, many projects in the early 1990s were financed with low cost U.S. dollar loans. Most borrowings were largely žunhedgedÓ because Asean currencies were pegged or linked to the greenback at the time (hedging is a process for lessening or eliminating risk by taking market position against your original position). As a result of currency devaluation, repayments have become much more expensive. This provide burden on the economy - non-performing loans may rise resulting in more bankruptcies.

If the value of our currency falls, we naturally become poorer as many things that we purchase from other countries cost more. The Ringgit has depreciated by 30% since the start of the crisis meaning that the locals have lost 30% of purchasing power. Imports become less affordable and foreign vacations become less attractive.

Currency risk has become even more critical for investors who invest in international markets. Foreign investment holdings may change in value as the currency value changes. A return of 20% may shrink to a single-digit return after taking account for currency loss. It could even translates to a net loss position.

Rising interest rates affect the capital value of bond investments - interest rate risk.. The value of bonds varies inversely with interest rates. When interest rates increase, the value of existing bonds go down because it is paying a lower rate then what investors could earn from newly-issued bonds. Bonds with longer maturities are usually more vulnerable to interest rate risk.

In addition, bond investors are likely to be concerned about credit risk - the risk that the issuer faces financial difficulty and will possibly default (fail to make timely payments of principal and interest). Bonds which enjoy better credit-rating are normally more secure than others dumped in the lower category. Lower-quality bonds normally compensate investors with higher yields. Credit-rating is normally conducted by independent rating parties.

During times of turbulence, many people prefer to leave their hard-earned money with banks or keep as cash reserves for a safe ride. Cash reserves have only minimal market risk. However, this may not be a perfect way to invest your money when you account for the effect of inflation - inflation risk.. A fixed depositor may ask what is inflation and what is the big deal?

Inflation is a general increase in the price level of goods and services. Inflation is usually a sign that an economy is not healthy and it shrinks every sen that you put in banks. Inflation has varied greatly over the past years.

Rapid inflation can have a corrosive effect on your investments. Given an imminent slowdown in the economy, many Malaysian are already feeling the pinch of higher prices of most goods. One Ringgit will buy you less things now compared to just a year ago.

These days, stability of political environment can have a dramatic impact on the financial markets - political risk.. Investors will usually demand for higher risk premiums when investing in markets notorious for political turbulence. Political unrest is a four-letter word for many foreign investors.

Thailand is one country where there is significant political risk as governments keep changing and investors do not know what the next government policies may be. Fortunately in Malaysia we do not have this problem because of our stable political system.

What have we all learned from the simple discussion above? - all investments have risk and we have discussed some of them which investors commonly face - currency, interest rate, inflation, credit, or political risk.

Even fixed deposits have risk - it is true that you would not lose a single sen in your bank but inflation will likely eat away your money. On the other hand, stocks which provide a hedge against inflation may be very volatile as they are vulnerable to short-term market fluctuation.

While it is impossible to virtually avoid risk, investors can learn on how to better manage risk It is therefore necessary for investors to understand the various risks involved when investing. The more you know about risk, the less nervous you will be.

Despite the various risks associated with investments, it can be reduced through diversification - a basic investor protection strategy. Spread your investment eggs. Do not put them all in one basket. Simply, if you own only one or two stocks in your portfolio, and that the stock price falls like a stone, your portfolio would be severely affected.

Given the drastic downturn in the local stockmarket, the risk of investing has reduced considerably. Just what is the degree of risk of buying a good stock like Maybank valued at around RM10 now compared to when it was at above RM20 just few months ago? Unfortunately, not many people actually buy during times when the risk is at its lowest (in this case buying Maybank at around RM10).

Investors with strong cash flows and belief in fundamentals with the capacity to absorb short-to-medium fluctuations (risk) should take advantage of the attractive valuation and low risk level whenever possible and adopt a counter-cyclical approach by selectively picking stocks or consider managed funds such as unit trusts and then wait to reap handsome rewards in the long-term. In other words, žbuy in gloom and profit in boomÓ.

Lastly, it may take a while before the current financial crisis stabilizes. When pessimism wanes and confidence returns, there will be some very good buying opportunities. The current attractive bargains in stocks may be already tempting for some investors who hope to buy at the bottoms with a very long-term view.

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Reproduced with permission from Normandy Services Sdn Bhd, Email:nassb@po.jaring.my Tel:603-4695560 Fax:603-2945561

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