4. Dealing With Long-term Risk Flashcards
1
Q
What is risk and reward?
A
- when a person takes out a financial decision, they do it because they believe it will bring them some type of reward
- they must also be aware that face certain risks
- overall the greater the overall reward, the greater the risk
2
Q
Possible risks?
A
- physical injury
- loss of or damage to possessions
- legal liability
- financial loss
3
Q
What is risk associated with?
A
- uncertainty -> future cannot be predicted accurately
- probability -> risk of an adverse event is higher when a situation makes it more likely that something will go wrong - e.g. someone lend money to a friend who is not creditworthy
- risk also arises when the actual outcome of an event or situation differs from what someone expected or planned for - e.g. someone opening a shop could find the shop is very popular + make a lot of money, or that isn’t + has to close down
4
Q
Relationship between risk and reward
A
- when a person takes a risk it is because their is a reason, a reward
- in order for someone to be willing to take what they perceive as risk, they must be offered a higher reward - therefore a financial product with risk needs to provide a form of high reward or return
- the consequence of this is somoene who wants high rewards must accept a higher level of risk of loss, where as someone who is keen to reduce/avoid risk must accept lower return
5
Q
What is a ‘trade-off’
A
- when deciding what combination of risk and reward to accept, a saver or investor pays for the chance of earning a higher reward by accepting more risk
- or the saver or investor pays for accepting less risk by agreeing to receive a lower reward
- one is traded off against the other
6
Q
Bank savings account risk
A
little risk but pays low interest rates
7
Q
Premium bonds risk
A
- carry no risk as they are 100% backed by the govt.
- but they have no guaranteed reward either + offer only the possibility of winning a prize
- NS&I says the annual prize fund interest rate is 1.40%
- it is calculated that someone with bonds of more than a certain amount has a good chance of winning prizes which equate to market interest rates
8
Q
Unit trust risk
A
- carry more risk as their value can go down as well as up according to stock market movements
- but the risk is spread over many different companies + there is the possibility of good returns
9
Q
Shares risk
A
- shares in an established company carry risk as there is no diversification but there is a reasonable chance of dividends
- shares in newly quoted company carry higher risk as the company is unknown, but if it is in an innovative sector, the return could be high
10
Q
Order of risk of financial products
A
- Shares in newly quoted company
- Shares in established company
- Unit trusts
- Bank savings account
- Premium bonds
11
Q
Methods of reward
A
- savings in a normal notice account (cash ISA or bond) earns a stated rate of interest that may be set in advance or may vary with changes in the general level of interest rates in the country
- investment products reward in two ways - earning interest + also make a capital gain -> e.g. hope to get an annual dividend from the company in shares + hope the market value of the shares will rise to sell for a capital gain or at least boost the value of their overall portfolio
12
Q
How have interest rates been in the UK?
A
- very slow in recent years + especially since 2009
- bank rate maintained at a very low rate of 0.50% for over seven years (2009 to 2016) before being lowered even further to 0.25% in 2016
- the Bank of England has kept interest rates very low in order to make it easier for people to borrow + for the economy to come out of its low level of activity
- increased in 2017 and 2018 to 0.5 and 0.75
- reduced to a historic low of 0.25 and then 0.1 in March 2020 due to Covid
13
Q
What is the impact of slow interest rates in the UK?
A
- this means very low rates are paid on saving accounts + this is an incentive for some savers to choose a riskier product in order to earn a higher return
- the financial regulators are concerned about this because risky investment products are unsustainable for many small savers + they may lose their money
14
Q
How do interest rates reflect risk?
A
- the interest rate paid when borrowing money reflects the risk to the lender
- other things being equal, the rate charged on a mortgage (secured loan) is cheaper then the rate charged on a personal loan (unsecured)
- individuals who poses a greater risk to a bank will have to pay a higher interest rate
- but the reward of being able to have immediate access to a home or car balances their disadvantage
15
Q
Affect of degree of risk acceptance?
A
- some people have a certain amount of risk acceptance or tolerance - they are willing to accept a risk but they probably set a limit to this + will take steps to manage it in order to reduce risk
- people with low risk acceptance might decide to invest in a collective scheme such as a unit trust, which invests in many companies instead of one
- people with higher risk acceptance might be willing to purchase high risk investments, such as shares in a new company in a high risk sector - in hope of earning a higher return
16
Q
What is an average risk tolerance?
A
- people with an average degree risk tolerance are likely to be willing to borrow money in order to buy their home + take the risk that something might happen to stop them from keeping up the payments
- they limit their risk by not borrowing more than they think they can afford
17
Q
What is high risk tolerance?
A
- people will high risk tolerance are willing to use a lot of credit products + are in danger of becoming over-indebted
- they risk losing their property that is secured on their loans
- they also risk getting a bad credit rating, which will affect their ability to borrow in the future
18
Q
What is risk averse?
A
- people who are very cautious + always try to avoid risk in whatever way they can
- the possibility they might gain money from making a particular investment is outweighed in their minds by the possibility that they might lose + are not willing to accept this exposure
- these people will avoid the risk of investing in the stock market by placing their savings somewhere safer e.g. bank savings account - this account will not pay them high interest but as long as the bank doesn’t fail, their money is secure
- they give up a higher reward in order to reduce their risk
19
Q
Risk averse opinion on mortgages
A
- someone is very risk averse may be unwilling to take out a mortgage to buy their home as they are afraid of the burden of debt
- they prefer to rent their home + to have the flexibility of being to move quickly if their income decreases
20
Q
What is risk transfer?
A
- a good way to manage risk as some risks are outside people’s control - but this does have a cost
- risk transfer means that a person who faces a risk decides to spend money on passing the risk to someone else, who will accept the financial responsibility
- e.g. insurance - people pay a premium + pass the risk of loss or damage onto the insurance company - mobile lost or stolen = insurer will recover the cost
21
Q
How does insurance work?
A
- insurance company collects premiums from everyone who insures the risk + it pays out compensation to those who are unlucky enough to suffer the loss
- the company must calculate the premiums carefully so that they are high enough to cover the losses that do happen + to make a profit on top of this
22
Q
Why are some people reluctant to take out insurance?
A
- some people are reluctant if it is not compulsory e.g. car insurance
- they feel they are wasting money by paying premiums against an event that may never happen
- some insurance policies are expensive + a person could be over-insured - however if a person sustains a loss or damage they will be happy they were insured
23
Q
Who buys insurance?
A
- a risk averse person would buy insurance in order to gain peace of mind
- a highly risk tolerant person would be content to take risk
24
Q
What are the two dimensions of risk?
A
- the impact of the risk
- the probability of the risk occurring
25
Q
What determines the impact of risk
A
- the amount of money involved
- the effect on lifestyle
- the timing of the event
- the frequency of the event
26
Q
How does the amount of money involved impact risk?
A
- the more money lost, the greater the impact on someone’s situation
- the amount of money needs to be compared to the persons income + wealth - e.g. £1000 would be significant to someone on a low income, but a small amount to a rich person
- best way to assess the significance of loss is to calculate how long the person would have to work to replenish the money - the longer it would take, the more significant the loss
27
Q
How does the effect on lifestyle impact risk?
A
- some risk events change someone’s life - e.g. physical injury in an accident, may take years of medical treatment, inability to work or study, may affect family/social life
- other events might be minor + a person recovers quickly with little bad effect
28
Q
How does the timing of the event affect impact?
A
- if someone loses their savings in their 20s - may appear disastrous but they have most of their life to save up the money again
- if someone aged 64 lost the money in their pension pot, it would be much more serious as they would not have the chance to make up the fund from earnings
29
Q
How does the frequency of event affect impact?
A
- if an event happens on several occasions - the accumulated impact will be much worse than if the same event happen only once
- e.g. if a persons house + content suffer flood damage once, the immediate distress will be great but the situation may be repaired eventually - especially if there is insurance
- but there are cases in the uk + elsewhere where the same area is flooded multiple times - they hv to repair + replace several times + insurance becomes very expensive as they are a high risk
30
Q
How can probability of risk be controlled?
A
- it is possible for someone to have an idea of the likelihood of an event happening if they have some control over the event + are able to take some risk reduction measures
- e.g. someone who deposits their money in a bank savings account is less likely to lose their money than someone who speculates by investing in shares
- however there are factors beyond the persons control still - e.g. a financial crisis - the savings account holder’s bank might fail + they lose their money (probability of this happening is low though)
