What most of us have been taught about risk is wrong, and it’s probably holding you back from obtaining real wealth.
Conventionally we’re taught that there’s a continuum of risk starting with low risk investments at one end of the spectrum to highly speculative, risky investments at the other. We’ve been led to believe that any investment can be placed somewhere along this continuum and in general, the higher the risk, the greater the potential rewards.
The fundamental problem with this logic is that you are taught to evaluate the risk in the investment itself. There’s something very important missing from the equation…and that’s you the investor.
Imagine you are considering undertaking a small property development. Traditionally you would look at this proposal in isolation and ask yourself, “Is this a risky venture?”
But here’s the thing: that question is impossible to answer in isolation because we still don’t know enough about you. Have you ever invested in property before? Have you ever completed a property development? Do you have the knowledge, skills, contacts and experience required to successfully complete a property development? If you have no, or limited, knowledge about council zoning, town planning, feasibility studies, building costs and the building process, no matter how good the deal itself might be on paper, jumping head long into your first property development will be a high risk proposition for you.
Over the years I’ve seen people make a lot of money out of real estate, but over the same time, in the same market and the same economic conditions, I’ve seen just as many people lose a lot of money. The difference is in the individual investor’s skills, contacts, strengths and expertise.
So in light of this new idea associated with risk assessment, let’s take a closer look at what really makes an investment more or less risky.
1. What is your area of expertise?
Your experience and network of contacts could be your biggest competitive advantage or your most potent risk factor. If you’re investing in something that is your speciality, you start with a built in advantage that will allow you to achieve a higher return than other investors.
2. What level of control do you have?
The more control you have over your investment, the lower your associated risk.
3. Is there transparency?
The more you know about what is happening with your investments, the lower your risk.
4. How liquid is your investment?
How easy it is to access your money by selling your investment and converting it (or part of it) to cash. The more liquidity, the lower your risk will be.
5. How do you achieve your returns?
Property investors receive returns from their investment property in four distinct ways;
a) Cash flow – the rent you receive
b) Capital growth – the increase in the value of your property as the overall values in the area increase
c) Forced appreciation – the increase in value you “manufacture” by undertaking renovations or redevelopment
d) Tax benefits – such as depreciation and tax deductions
The more secure the returns on your investment, and the less dependent you are on any one of these four categories, the less risky your investment will be.
6. Is your equity safe?
Is the initial money you outlaid to acquire your investment secure should the investment fail?
7. What is your personal liability?
When you make an investment, you are sometimes required to provide a personal guarantee. If you do, this gives others (usually the banks) the right to pursue you personally for any lost funds should things go pear shaped.
8. What is the market risk?
Some risks are inescapable as they are inherent to certain markets. For example if you invest in tourism, you are subject to the market collapsing if a natural disaster occurs, such as a cyclone, a Tsunami or a disease outbreak.
9. The specific investment risk
This is the risk specific to the particular investment itself. Is it the right property, in the right suburb, at the right price and at the right time in the cycle?
When assessing risk, most investors focus only on the last two factors – the market risk and specific investment risk. This tunnel vision often means that they fail to take account of other critical underlying factors that, in many cases, are more significant.
Your take home lesson should be that while most investors spend vast amounts of time analysing the deal, you must spend more time understanding yourself better.
My risk spectrum is different to yours and relates to my expertise, my background, the things I’ve done, the lessons I’ve learned and the mistakes I’ve made. Which means that some types of investment are much less risky for me than for you!
In the same way, you have your own risk profile and you need to take the time to assess what that might be. Whenever you consider putting your money into an investment, don’t make the mistake of analysing the investment in isolation – look at that investment in relation to yourself. What type of investment choices are low risk for you? What type of investment is medium risk for you? And which type of investment is high risk for you?
Remember that even though all investment comes with some degree of associated risk, you can change this by developing expertise in an area and make the journey to your own financial freedom a low risk, high return venture.