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Investment risk: Internalities


by daniel archibald

 

Every investor understands that there is really no free lunch when it comes to trying to earn a return from an asset. In all financial transactions, any potential reward comes with a level of risk, which is usually in the form of the uncertainty of future earnings. For example, when buying an investment property, there is a number of future cash flows that are uncertain, such as rent (driven by rent increases and vacancy rates), maintenance costs and future sale price. 

These risks to the future expected cash flows of an asset is known as investment risk. This is the risk to the financial performance of the investment and is often measured as the estimated volatility of returns (generally on an annual basis). Assuming the past as a fair indicator of the future, this can be measured by looking at historical volatility of returns. Other techniques include only measuring downside risk (i.e. how much volatility in losses) or by assessing the volatility measure implied by option prices (if there are enough options over the asset). 

Again, this risk is simply a measure of the uncertainty of asset performance. This is primarily a way to understand the risk to financial returns that arise from investment decisions and is the major risk considered by investors. This risk is driven by a number of drivers with the main types of investment risk being market risk (risk from market-wide drivers such as economic conditions and money supply), credit risk (risk of counterparty failing to meet obligations), and liquidity risk (risk of not being able to sell an asset at a reasonable price quickly). For investors that utilise external managers (e.g. fund managers) to invest on their behalf, they would also be exposed to manager risk, which is the risk that the manager does not act or perform as expected. 

Whilst these risks to financial returns are a top priority, many investors might also have non-financial investment objectives, which might include internal aims and goals. Such internalities are more about the investor than the investment, and might include reputation, funding, independency and emotional well-being.

  • Risks to reputation can flow from a number of investment sources. Firstly, a seasoned investor might have their skill and expertise questioned in the event of a period of performance. This is obviously linked to the investment risks mentioned above. Reputation, however, might also be affected by the types of investments made, even if performance is good. For example, investors that have focus on green investments might receive a boost to their reputation, whilst that invest in socially-unacceptable ventures might have the opposite consequence.
  • Risks to funding is largely a risk for fund managers, who's business model and legacy generally depends on convincing other investors to utilise their skills, either by getting new contributions or keeping existing unitholders. This is directly related to the managers reputation, but can also be affected by things outside of their control (e.g. economic conditions, legislative changes, etc).
  • Risks to independency generally arise out of the sunk cost fallacy - i.e. if you have already put a lot of money into an investment, you're likely to keep on sinking capital. This creates a dependency relationship between the asset and the investor, risking the ability of the investor to make independent investment decisions.
  • Risks to emotional well-being tend to largely flow from investment risks and is a main focus when trying to understand an investor's risk tolerance. Emotional well-being, however, can also be affected by social interactions within the decision-making process. For example, an investor might get a boost from the relationship they have with their financial advisor, or might get negatively affected when a fund manager invests in something to which they are averse, or perhaps have a conflicted relationship with a tenant in an investment property. A large emotional burden for some investors might come from trying to manage a direct investment, such as an investment property, especially if the investor takes on tasks such as renovations and other maintenance. 

Most investors will look to invest in a less complicated way, focussing on solely the risks to financial performance. This can be wise, but does require an agnostic view on non-financial outcomes. Where other objectives exist, such as internalities or even social impact goals, understanding associated risks can help to ensure they are managed and controlled along with core investment risks.

 

LBW Wealth Management is an Authorised Representative of Wealthsure Financial Services Pty Limited AFSL 326450

This article has been prepared by LBW's investment committee based on its understanding of current regulatory requirements and laws. It is not considered advice and provides general information pertaining to our ideology surrounding future asset allocation strategies. It does not take into account each client's individual objectives, financial situation or needs. If you would like to know how LBW's understanding of the current environment impacts on your portfolio please contact a Financial Adviser and to discuss your options or before making an investment decisions. 

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