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5 Common Misconceptions People Have About Risk That Could Have Disastrous Results

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Ryan Ong

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Some people think of finance as a big casino. That’s wrong, because financial markets are even less predictable. Gambling has set parameters – you can estimate the odds quite accurately in roulette or Blackjack. But in financial markets, assessing risk is like trying to predict where each raindrop will fall in a storm. Here’s what many new investors don’t get about risk:

 

1. Just Because it’s Working, That Doesn’t Mean You’re not Taking on Too Much Risk

There’s a saying that finance is 80% psychology, 20% maths – and this is a prime example.

At some point, you’re going to meet someone made a lot of money screwing around on Forex, investing in quesionable structured deposits, taking a chance on land banking, etc.

In most cases, they’ll grossly underestimate the amount of risk they’re taking. Because look at how well they’ve done so far! All that talk about risk must be pure hype, right?

Llet’s put it in perspective: I crossed the road without looking this morning, and nothing happened. Shoud I then assume it’s always safe to cross without looking?

Just because I took a risk and it paid off, that doesn’t mean I didn’t take a huge risk. It just means I got away with it this time. And the smart thing would be to never do it again.

But to too many people, getting away with a high risk investment psychologically lowers the risk for them – they feel it’s less unpredictable than it really is, because they’re still dazzled by the payoff.

This is how lottery addictions form (the occasional consolation prize is enough to turn a punter into an addict), how Ponzi schemes get the first level of suckers to re-invest, and how jackpot machines make you gamble away $500 while paying out $150.

 

2. Controlled Risk Taking is Less Dangerous (Financially) Than Complete Refusal to Take Risks

Some investors are so averse to loss, they only want “risk-free” ways of growing their money. So they tend toward low risk, low return products – most often fixed deposits.

Products like fixed deposits guarantee your money alright. Just like they also guarantee poor returns. A good fixed deposit deal would be 1% (many are even lower), whereas the rate of inflation marches on at around 3%.

So in effect, you’re being “guaranteed” negative 2% returns. Overall, the method can be described as “I will lose money in order to avoid losing money.”

Neither extreme – too much or too little risk – is financially healthy. You need to have some investments that are as safe as possible, and the rest in more volatile investments to match or beat inflation.

Talk to an independent financial advisor; your diversification will depend on your own needs. But don’t chuck all your money into low risk products, and then wonder where all that money went 30 years down the road.

 

3. Capital Protection Does Not Mean “No Risk”

The advertising for some financial products (keep an eye on structured deposits) imply you have nothing to lose, because in the worst case scenario you get your capital back (i.e. the initial amount you invested). But capital protection doesn’t mean you aren’t risking a lot of money.

Let’s say you put money in a structured deposit, that has 9% returns. You’re required to commit the money for a period of six years. If something does go wrong, the bank will call the deposit (pull the plug), and you get back the money you invested.

But what happens if you commit the money for five years, and before the sixth the bank calls the deposit?

You’ll get your capital back alright. But by then, you’ve lost the money you could have made investing elsewhere (e.g. in an insurance policy). Also remember that inflation progresses at around 3% per year, so your capital is worth a lot less than it was five years ago. You’ve effectively lost money, by letting it stagnate.

Also, during the time the money was committed, you had no access to it. You may have have had to use credit, or taken out loans that you wouldn’t have had to if you’d held on to the money.

Capital protection does provide some buffer against risk, but don’t think of it as the be-all and end-all of risk assessment.

 

4. Your Fund Manager is Less Inclined to Avoid Risk Than You Imagine

Fund managers will point out that, if a fund fails to make money (or loses money), they will lose their performance bonus. So why would they take on too much risk? They stand to lose as well.

I’ll tell you why: because of the way performance bonuses are paid out. When a fund generates high returns, the fund manager gets a bigger bonus. But to generate high returns, a degree of risk-taking is involved.

So fund managers often gamble on the small possibility of a blow-up, in order to get higher returns / bigger bonuses. Odds are, the blow-up won’t happen in the first year, second, third, etc.

Over a period of say, five years, a fund manager can collect quite a lot in bonuses. But say on the sixth year, bad luck strikes and the fund collapses. You lose your investment, along with all the returns you’ve re-invested over the years (because the performance was so good! See point 1).

The fund manager shrugs, apologises, and maybe even gets fired. But does he really care? He’s already amassed five years’ worth of performance bonuses, and he doesn’t have to pay you back one cent.

This is how finance “experts” end up with yachts and cars, and their investors end up retiring at 90.

So don’t completely trust fund managers. Pay no attention to their “we’re in this together” argument, because they stand to make money even if you don’t.

The best investment is time. Time taken to learn the basics, and to manage your portflio with a degree of independence.

 

5. Financial Forecasts are Bad Predictors of Risk

Financial forecasting is not a science. The best we can do is study past events and their probable causes, and see how closely it matches the present.

Whether or not this actually works depends on which historian / risk analyst you ask. Let’s not even go there; I can’t tell you what I ate for lunch last week, let alone comment on the cyclical nature of history. Suffice it to say that the method is questionable, because it’s hard to determine the exact cause(s) of a financial collapse, even in hindsight.

The sub-prime mortgage crisis, the economic collapse of ’08, and September 11th all destroyed funds, with little or no “historical precedent” to warn they were coming. So when you read forecasts involving risk prediction, take it with two heaping handfuls of salt.

 

Have you ever made a bad mistake with risk assessment? Comment and let us know! Save someone’s wallet!

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Ryan Ong

I was a freelance writer for over a decade, and covered topics from music to super-contagious foot diseases. I took this job because I believe financial news should be accessible and fun to read. Also, because the assignments don't involve shouting teenagers and debilitating plagues.