"Risk is the price you pay for opportunity"
When it comes to investing, no one likes risk. Every investor hopes for the low-risk high-reward investment that will guarantee a return on their investment without having to risk anything in the process. Unfortunately, there is no such thing as a high yielding investment with no risk, and although you can reduce, manage and even hedge against risks to avoid them having too much of a negative impact on you and your portfolio, they cannot however, be eliminated altogether.
The fact is that risk is inseparable from return. Every investment involves some degree of risk and in order to utilize your capital to its maximum potential, rather than not invest at all, you should assess your risk tolerance level and create an investment strategy that fits your predetermined criteria. Some risks can be directly managed; other risks are largely beyond the control of company management. Sometimes, the most you can do is to try to anticipate likely risks, assess the potential impact they may have, and design a plan to respond to possible adverse effects.
People generally tend to think of risk in predominantly negative terms. However, in the investment world, risk is necessary and cannot be separated from the desired outcome. The fear of the unknown and the unpredictability of some investments has paralyzed many investors and has cost them millions in missed opportunities, in exchange for a sense of security for either their money, or themselves. As Robert Arnott said "In investing, what is comfortable is rarely profitable."
IDENTIFY YOUR OPPONENT
Knowing what risks an investment could be faced with in the future is the first step to being able to avoid, or at least minimize potential risks. Overall, there are several factors that could pose a threat to an investment. These fall into one of four primary categories:
1. Market Risk
Market risk is when there is a significant change in the particular marketplace in which a you are invested. With real estate investments, this could pertain to a specific market demographic, area, state or country but can also be an adjustment or shift within the market sector that you have invested in.
For example, let’s say you own an office building in New York. There are two types of market risks that could affect your investment. First, a change in the New York real estate market could either positively or negatively impact your investment. The second market risk that you could face would be if there is a major announcement or event that influences offices on a national or global scale. This would also directly control the performance of your investment.
Another element of market risk is the risk of being overshadowed by competitors in your specific field. If your company sells watches and a new brand of watches gains popularity, your sales could take a hit and you could be forced to either lower your prices, which could affect your bottom line. The same could happen with a real estate investment. A high demand for housing within a small community might transform into a serious over-supply problem when a competitor builds a new development.
2. Credit Risk
The risk of not having enough funds to pay its bills is referred to as credit risk. Also within this category is when your company extends a line of credit to your customers, or, as it relates to real estate, your tenants. By providing your tenants with credits or with the ability to pay late, you accept a financial risk of the tenant defaulting on their payment, which can, in turn, cause you to be hit by the other component of credit risk; the inability to pay your vendors, mortgage or loan payments and employees.
Credit risks are calculated based on the debtor's overall ability to pay an obligation or repay a loan according to its original terms. This is why, as a real estate owner, it is crucial that every tenant is carefully vetted and assessed to ensure that they will be able to fulfil their rent responsibility to you over the long term.
3. Liquidity Risk
Liquidity risk refers to how easily you can convert assets into cash should you suddenly have the need for the funds. Different asset classes often have a different level of liquidity and can therefore carry different amounts of liquidity risk. Stocks of large, blue-chip companies are extremely liquid and can be bought and sold within a very short period of time. Other assets however, such as real estate, are much less liquid and can often take much longer to sell.
The lack of marketability of an asset that can't be bought or sold fast enough poses a threat to you as the investor, in the event that you want to cash in an asset in order to avoid or minimize a loss in the event of a market downturn.
4. Operational Risk
Operational risks can occur as a result of your regular business activities and include lawsuits, fraud and employee issues. These risks mostly result from deficiencies in the internal procedures of your business rather than from external forces like economic events such as recessions and changes in interest rates, or political events, natural disasters and terror attacks.
Primarily a result of human actions, operational risk highlights the importance of choosing your employees, partners and associates carefully. One wrong move by a single individual in your organization can negatively impact your entire portfolio, investment or business.
Each risk factor has its own methods and techniques that investors use to eliminate or minimize the risk. For example, in order to avoid market risk, you could diversify your investments though various asset classes or invest in different markets or sectors. But diversification in itself will not protect you against operational risk. Your management team could still face internal challenges that could have a negative impact on your entire portfolio.
In an attempt to eliminate liquidity risk, you might choose to invest only in liquid assets such as stocks. And while you now own an extremely liquid portfolio, you are still exposed to other risks like credit risks that the companies you own could encounter as well as the various market risks that could affect them.
Investing long-term in assets with a proven track record of growth and profitability often minimizes the effects of short-term market volatility and difficulties.
In spite of this, knowledge and understanding in specific market situations can be a one size fits all solution to mitigate many of the risks you could face. Robert Kiyosaki in his book Rich Dad's Guide to Investing writes, “In reality, investments are not risky, it’s the lack of education, experience and excess cash that makes it risky for the average investor”. And, while a certain element of risk always remains, these attributes definitely help when it comes to reducing risk.
RISK vs REWARD
The Ideal Balance
The risk-reward ratio is the degree of risk you are taking on for the potential reward. This is calculated as a ratio. The goal of every investor is to maximize the units of profit against every unit of risk.
For example, if you invest $1 to earn $1, and you could possibly lose your $1 by doing so, your risk-reward ratio is 1:1. If, however, your maximum risk in this scenario is that you could lose 50c, your risk-reward ratio would be 2:1, meaning that you are risking only half as much as you could possibly earn. In order to be a profitable investor, you should always aim to have a risk-reward ratio which is greater than 1:1.
This is true if the chance of profiting is the same as the risk of losing money. If the likelihood of losing your $1 is greater than the probability of earning $1, although it may technically be a 1:1 chance, it is not a desired investment for any sophisticated investor. In fact, the ratio would have to be adjusted as the chance of losing $1 is no longer the name as the possibility of receiving $1.
It is also noteworthy that the risk-reward ratio of a real estate investment will change over time, it may well have started out as a relatively high-risk investment and as the property increases in value, the risk-reward ratio for your initial amount invested changes to a more desirable number. This could also occur because of various additional factors, both internal and external to your investment. Market conditions, inflation, and the state of the economy will all affect the risk-reward ratio to a broader extent, while the physical condition of the property, age and health of your tenants and the skills and experience of your management team will determine the ratio on an individual level.
As you pay off your mortgage, build equity and recoup some of your initial investment the risk on your initial investment is greatly diminished and you can often afford to take on additional risk to increase your profitability. You also have the option to leave your investment as it is and enjoy the peace of mind that a lower-risk investment provides.
On the flip side, some factors can negatively alter the risk-reward ratio. An investment that might have started out as a relatively low-risk investment can sometimes become riskier due to the many moving parts that comprise every investment. Market downturns, a decline in asset prices, higher interest rates as well as bad health or financial difficulties of a tenant are just some of the components that may negatively affect the ratio. When this happens, it may be time for you to consider selling your property or pay off some of the financing to reduce risk.
Your view of the future will heighten your risk tolerance as you may be prepared to take on more risk in the anticipation of a heightened return in the future.
RISK TOLERANCE LEVEL
There is no doubt that many of us will have encountered investments which promise the world for minimal risk. These can be very eye-catching and tempting and many people are naturally attracted to these offers, although the fact remains that if there is no risk with an investment there is no return, and in most cases, the higher the return the higher the risk. Every real estate investor is different and we all look for different risk-reward ratios and investment returns. The truth is that no one strategy fits for everyone. A 20 year old with no debt and no family is not going to have the same risk tolerance as a 40 year old with a large family and a mortgage. The question you must ask yourself is whether the level of risk versus the possible reward is worth it in your current situation.
Though investing in a savings account is your safest option, your gains will be minimal given the extremely low-interest rates. In a way, you will have paid a very expensive price for the security you receive, namely the opportunity cost. Thus, the expression, “Security is often the cause of scarcity”. Many people are risk-averse. They don’t invest for fear of losing their capital. The fact is, that by not taking the risk to invest, they are unconsciously falling victim to the effects of inflation.
Most investors start off with a higher risk tolerance level and, as the age and approach retirement age, will shift the risk-reward towards safer investment opportunities. On the other hand, people who don’t have anything at all saved up for a rainy day or an emergency fund should probably steer away from riskier or mostly illiquid investments.
No matter what your risk tolerance level, knowing your tong-term investment objectives and goals will bring you one step closer to defining your investment strategy and will narrow your search for the perfect investment to add to your portfolio.
As Robert Kiyosaki explains, "It is not the investment that is risky but the investor who doesn't have the adequate skills that makes the investment a higher risk." With our group of select Bridgehall Group Partners, we bring you a winning combination of high-quality investments, paired with an experienced and knowledgeable management team to provide you with the ultimate recipe for a seamless, low-risk experience, while maximizing returns in the safest way possible.