Evaluating Risk in Alternative Investments

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Created on Friday, 10 September 2010 14:55

Written by Sara Nunnally, Editor, Smart Investing Daily

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The topic of alternative investments has hit the ground running on the newswires. A CNBC article earlier this week noted, "With the stock market bland and the bond market bubbling, investors may have to search elsewhere in the months ahead for return."

Far from the spot-on alternative investments Smart Investing Daily covered on Wednesday, the CNBC article went on to list four investments that were "outside" of the mainstream:

1. Grains (Corn and Wheat)

2. The Australian Dollar

3. The Japanese Yen

4. Emerging Market Infrastructure

I’m not here to judge whether or not these are good investments... rather, I’d like to help you decide whether these are good investments for you.

You see, after I read through the article, I scrolled down to read the comments. Many readers were saying one thing. Here’s an example:

Commodities and FX?! ! You're kidding right ????? The people who posted this article without a 100 word dissertation about the immense risks involved should go to jail.

Now, you could argue that it’s up to the investor to determine both how risky an investment is and how much risk they’re willing to take on, but when you read news articles talking about food riots in Mozambique and grain shortages in Russia, the U.S. dollar hitting a 15-year low against the Japanese yen, and surging copper prices buoying producers in Chile, it’s hard not to get excited about these alternative investments.

And whether or not you get involved in any of these alternative choices is wholly based on how risky these investments are to you.

How to Determine Risk

The not-so-simple definition of risk is "the standard deviation of the historical returns or average returns for a specific investment." By finding the average return or mean return for a specific time frame, you can determine how much of a return you can expect from an investment. The standard deviation from that average, or how much volatility the investment has had in that specific time frame, tells you how risky that investment is.

It gets even more complicated when you’re dealing with different time frames and your own personal investment horizon. That is to say, a buy-and-hold investor will have a very different view of risk than someone who trades the market every day.

The best way to tell how risky an investment is, is to compare it to something that’s not as risky, like a government bond (though the debate on a possible bubble in bonds goes on).

Here’s one calculation: (Return on Government Bond) - (Estimated Return on Investment) = Risk Premium

(This is an oversimplification, so for a complete calculation, see the Investopedia article called, "Calculating the Equity Risk Premium.")

What’s Your Risk Tolerance?

In general, there are certain "characteristics" of you, the investor, that help determine your risk tolerance. They are age, financial goals, income and experience.

Though not a hard-and-fast rule, the younger you are, the more time you have to invest in the markets. This means that you have more chances to recoup any losses your portfolio incurs near the beginning of your portfolio creation.

This isn’t a revolutionary concept, of course, but the others tend to get swept under the rug.

What are your financial goals? Are you saving for retirement, or a new vacation home? Maybe you are already retired and looking to get your estate in order... You might approach risky investments differently depending on what your goals are because risk affects these goals in different ways.

If you’re investing to fund necessary objectives, like your child’s college fund or your retirement, your risk tolerance should be less than someone who’s looking to buy a second home in a tropical resort.

How much capital can you afford to invest? Do you have a lot of disposable income, or are you living on a pension? Is your wealth tied up in real estate, or is your trading account flush with cash? Just like with your financial goals, your "risk capital" will be different for each situation. A $10,000 trade might be a drop in the bucket for a high net-worth investor, but not for the folks that don’t have a lot of liquid cash. In some cases, that might be the entirety of his or her portfolio.

A key point here, however, is still to only risk (at whatever level) money that you can afford to lose.

And that leads us to experience.

Experience doesn’t just mean the number of years you’ve been an investor. It also means how familiar you are with different investment vehicles, like options or futures. If you’ve been investing in stocks for 30 years but never touched an option, your risk tolerance for options investing should be very low at first, so you get a feel for this market before risking a lot of capital.

(Investing doesn't have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Jared Levy simplify the stock market for you with our easy-to-understand investment articles.)

A lot of managing risk is common sense... It requires due diligence before following a trend or hopping into the latest hyped-up investment – no matter how much risk you can afford to take on. No one wants to be on the losing side of a trade.

With the four "alternative" investments listed in that CNBC article, you can determine how risky they are to your portfolio. And don’t forget that there are many types of investments in these alternatives... everything from futures and options to ETFs.

They say the best defense is a good offense, but they also say defense wins championships...

I say the best defense is knowledge, and a good plan. Set your financial goals and know your risk tolerance. Invest accordingly, and don’t be afraid to objectively re-evaluate your strategies. You at 25 are a very different investor than you at 55.

And you at 75? Well, here’s to hoping you’re living the good life.

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