CHAPTER 4

RISK IN THE RETIREMENT

PLANNING

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OUTLINES
• General definition of risks
• Types of investment risk
• Subjective risk and
investment portfolio in
retirement planning
• Risk profiling for determining
the degree of acceptable risk

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Introduction
• Before any investment recommendation is made, need to
understand the client’s actual risk situation and attitude
towards risk.
• Client’s capacity to risk a loss?
• Client’s risk tolerance?

• The Concept Of Risk

• Risk is a subjective concept because it involves perception.
• economists, behavioural experts, risk theorist, clients
differ in their concept of risk.

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Understanding risk
• Risks exist when the actual return differ from the
expected return
• Risk is present in all investment assets. Exception to
“risk-free asset” in the portfolio theory.
• Risk-free investments are considered to be
reasonably certain to gain at the level predicted. The
expected return and actual return are likely to be
about the same.

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Investment risk components

Business Risk

Components of Investment
Financing Risk

Interest Rate Risk

Risk

Inflation Risk

Foreign Exchange
Risk

Political Risk

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 1. Business risk
• Risks associated with running a business, whether a
company’s can generate revenue to cover operating expenses

Profit = revenue – expenses

• Operating loss (revenue < expenses)? or profit (earnings)?

• Revenue due to competition or substitution.

• Expenses due to rising raw material or labor costs.

• If company cannot pass on costs to consumer, they have to

sacrifice their earnings.
• Companies with high fixed cost tend to have higher business risk.
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• Different companies face different level of risk

Elasticity of = % change in sales quantity

demand % change in price of a product

• Coefficient of elasticity
• < 1 = inelastic
• indicating low risk (eg: Companies producing essential goods &
services)
• > 1 = elastic
• indicating high risk (eg: Companies on IT & technology)
• Planner should avoid investing in high business risk companies
for accumulation of retirement resources 7
 2. Financing risk
• Risks associated with the usage of external
funds in running the business
• Capital funds are required to run/expand
business activities.
• Example of external funds:
• loans and advances given by creditors, fund
raised through issuance of loan stock and
bond.
• Cost of external funding:
• payment of fixed interest expenses at
regular time interval.
• A company with little external funding have
low financing risk

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Credit risk
• Credit risk refers to the risk that a borrower may not repay a
loan and that the lender may lose the principal of the loan or
the interest associated with it.
• Credit risk arises because borrowers expect to use future
cash flows to pay current debts; it's almost never possible to
ensure that borrowers will definitely have the funds to repay
their debts.
• Interest payments from the borrower or issuer of a debt
obligation are a lender's or investor's reward for assuming
credit risk.

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Credit risk
• Credit risks are calculated based on the borrowers' overall
ability to repay.

• If an investor is thinking about investing in a bond, he looks at the

credit rating of the bond.
• low rating high risk of default.
• Conversely, high rating safe investment.

• Agencies such as Moody's and Fitch, RAM evaluate the credit risks of
thousands of corporate bond issuers and municipalities on an
ongoing basis.

• High risk high interest rate

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Market risk
• Market risk is the possibility for an investor to experience losses due to
factors that affect the overall performance of the financial markets in
which he is involved.

• Market risk, also called "systematic risk," cannot be eliminated through

diversification, though it can be hedged against.

• Sources of market risk include recessions, political turmoil, changes in

interest rates, natural disasters and terrorist attacks.

• The most common types of market risks include interest rate risk,
equity risk, currency risk and commodity risk.

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3. Interest rate risk
• Changes on interest rate announced by
the Central Bank of Malaysia (BNM)
affect the movement of securities.
• Downward announcement
• good for share market example: lower
interest expense,
• good for fixed income securities 
increase prices
• Bad for clients and business entities with >
fixed deposits
• Upward announcement (higher
interest rate)
• Reduced prices of securities: shares,
warrants and bonds. Alternatively seek
protection in the derivative market.
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4. Inflation risk
• The risk that inflation will undermine an
investment's returns through a decline in
purchasing power.
• Bond payments are most at inflationary risk
because their payouts are generally based on
fixed interest rates and an increase in inflation
diminishes their purchasing power.
• Example: You buy a bond with a coupon rate
of 4%. The inflation rate is at 2%. Even though
you are earning 4% on your money, inflation is
chipping 2% of it away only leaving you with
2% of your money or purchase power upon
receiving your interest payments.

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 4. Inflation risk
• Investor expect rate of return to be high enough to at least
cover inflation rate.
• Otherwise an open economy may lead to leakage of funds which will
eventually lead to shortage of fund and tight liquidity.
• Thus market intervention rate is preferred.
• All investment expert and fund managers have their own
forecast of inflation rate. This market perception affect prices of
securities.
• Monitoring closely the changes &price adjustments of essential
goods, one will be able to form an opinion on the trend of
inflation rate.
• https://www.usbank.com/financialiq/invest-your-money/invest
ment-strategies/effects-of-inflation-on-investments.html
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5. Foreign Exchange Risk
• Foreign exchange risk is a financial risk that exists when a
financial transaction is denominated in a currency other than
that of the base currency of the company.

• The exchange risk arises when there is a risk of an unfavourable

change in exchange rate between the domestic currency and
the denominated currency before the date when the
transaction is completed
• Any appreciation/depreciation of the base currency or the
depreciation/appreciation of the denominated currency will
affect the cash flows emanating from that transaction.

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5. Foreign Exchange Risk

• Foreign exchange risk can affect investors, who trade in

international markets, and businesses engaged in the
import/export of products or services to multiple countries.

• The proceeds of a closed trade, whether its a profit or loss,

will be denominated in the foreign currency and will need to
be converted back to the investor's base currency.
• Fluctuations in the exchange rate could adversely affect this
conversion resulting in a lower than expected amount.

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5. Foreign exchange risk
• For importers, if:
• RM stronger than USD lower COGS and more profit

• RM weaker than USD higher cost thus less profit

• For exporters, if:

• RM stronger than USD increase COGS and lower profit

• RM weaker than USD reduce cost and increase profit

*If contact is in USD

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Foreign Exchange Risk Example

• An American dairy company signs a contract to buy 100 cases of cheese

from a French retailer for €50 per case, or €5,000 total, with payment
due at the time of delivery. The American company agrees to this
contract at a time when the Euro and the US Dollar are of equal value, so
€1 = $1. Thus, the American company expects that when they accept
delivery of the cheese, they will be obligated to pay the agreed upon
amount of €5,000, which at the time of the sale was $5,000.

• However, it will take a few months for delivery of the cheese. In the
meantime, due to unforeseen circumstances, the value of the US Dollar
depreciates versus the Euro to where at the time of delivery €1 = $1.10.
The contracted price is still €5,000 but now the US Dollar amount is
$5,500, which is the amount that the American dairy company will have
to pay.
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5. Foreign exchange risk

• FX risk also affects investors making international

investments.
• For example, if money must be converted to another
currency to make a certain investment, then any changes in
the currency exchange rate will cause that investment's value
to either decrease or increase when the investment is sold
and converted back into the original currency.

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Example: Some corporations do borrowed loans and
advances denominated in foreign countries.

• A listed corporation in Bursa Malaysia have taken a foreign

currency loan denominated in US dollar amounted
USRM200 million at the time when the exchange rate is
USD1= RM2.50.
• The loan amount = RM500 million. (2.50*200M)
• After crisis; rate pegged at USRM1= RM3.80;
• loan increase to RM760 million. (3.80*200M)
• The borrower has foreign exchange loss of:
• RM260 million. ( 760-500)M

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• The ringgit is pegged at USD1= RM3.80;
• loan is RM760 million. (3.80*200M)

• If US dollar drop to USRM1= RM3.30, the borrowing

corporation only need to repay the loan of:
• = 3.30 * 200M = RM660 million instead of RM760M

• Therefore a foreign exchange gain of:

• = RM100M. (760-660)M

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 Foreign exchange risk also affect investor with
investment assets denominated in foreign
currencies

Example: Eddy invested RM380,000 in a unit trust scheme that invested

funds in US dollar. At the point of entry, the rate was USD1= RM3.80.
The equivalent of the original investment amount was therefore USD
100K. Assuming one year later the investment of USD100K has gone up
by 10%. If the exchange rate changed to USD1 =RM3.30, how much the
loss in investment?

• RM380K 380,000/3.80 = USD100,000

• value of investment 100K(1.10) = 110K which then to be liquidated.
• USD110K x RM3.30 = RM363,000
• Loss of investment = RM380,000 - RM363,000 = RM17,000

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 5. Foreign Exchange risk exposure
occurs when a company buys
products or services in a
Transaction different currency or has
receivables in another currency
than their operating currency

Occurs when the volatility in the

Types of Foreign exchange rate market can cause
Exchange Risks Economic
changes in the market value of
the company.

occurs when a company’s

financial statement reporting is
Translation
affected by the exchange rate
volatility.

Refer to https://www.wallstreetmojo.com/exchange-rate-risk/ for 23

details.
7. Political
risk

• The risk where investment's returns could suffer as a result of political

changes or instability in a country.
• The changes therefore poses a risk to the investors who have
investments in financial instruments like debt funds, mutual funds,
equity, etc.
• Instability could stem from a change in government, legislative bodies,
other foreign policy makers or military control, corruption, terrorism,
etc.
• These factors are related to the politics of a country may arise due to
change in a political scenario, which further might result in a change in
the regulations of the nation.

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7. Political Risk
• The outcome of a political risk could drag down investment returns or
even go so far as to remove the ability to withdraw capital from an
investment.
• Change in government leads to a change in regulations and changes in
business scenarios. For example, any change in the corporate tax rate by
the ruling government can change corporate profits.
• There are certain legal aspects also which may challenge the way of
doing business and lower profitability and enhance risks for the investors.
• This risk may arise at any level, such as the national level, federal level,
state level, etc.

• Frequency is in the third world where political instability is much

in the country.

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Uncertainty

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 Uncertainty and Risk
• Uncertainty simply means the lack of certainty or sureness of
an event, due to lack of information.
• The term is often widely used in business as there are many
events that are beyond a company's control that can greatly
affect its transactions.
• Objective risk(also called degree of risk)
• Defined as the relative variation of actual loss from expected loss.
• Subjective risk (also known as perceived risk)
• Defined as uncertainty based on a person’s mental condition or state of
mind.
• Influenced by beliefs, past experience and values in their
interpretation.
• Can affect a person’s behavior.

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Risk Behaviors
• Some people will be more willing to accept high risks compare to others
in the same set of circumstances.
• Must recommend investments vehicles that align with the client’s type. 3
types of human risk behaviors:
1. Risk seeking
• Risk as opportunity rather than a threat
2. Risk indifferent
• Indifferent: “Who-care-what” attitude.
3. Risk aversion
• Risk is a threat. Prefer certainty over uncertainty; pessimistic
• Most people fall under this category.
https://www.youtube.com/watch?v=mqKIMdpAZLw

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 Misjudging
Short-run
the scale of
trend
the risk

Mental
Misjudge-
denial of
ments
risk

Factors
Influence of
Individual’s affecting
bias
belief rational
attitudes
thinking

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Factors affecting rational thinking

• Influence of bias attitudes

• Accessibility bias
• Intimacy bias
• evidence bias
• Illusion of control bias

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 Risk Personality
• Psychologists findings: Four types of life circumstances concerning
risk taking:
1. Money
Risks concerning loss of capital, e.g. business ventures

2. Physical
Risks concerning loss of life. e.g: sky diving

3. Social
Risks concerning loss of face, eg. Singing in a contest

4. Ethical
Risks concerning loss of freedom, e.g drug trafficking

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Risk Tolerance and Demographic
Attributes
1. Age: age risk tolerance

2. Sex: men women

3. Marital status: married single

4. Occupation: public private

5. Wealth: absolute/relative risk tolerance
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Risk Profile of the Client

Risk profile is his set of behavior when he participates

in investment
 does he lean away from risk or move towards it?
Risk profiling
To draw up a risk profile consisting of specifically
designed questionnaire to help assess the client’s
personality and the type & degree of risk acceptable to
him.
See the example of risk profiler format (page 4-14 to 4-15)
 client general preference & inclination towards the type
of investment & investment risk. 33
 Client’s investment risk profile
assessment: Example of questions:
• 1. identify the sort of return you prefer over a five year investment
period:
a) 5 to 10%
b) 10 to 15%
c) 15 to 20%
d) More than 20%

• 2. identify the investment time length you are most willing to put
aside your money.
a) I am likely to liquidate my investment within the next 2 years
b) I am likely to liquidate my investment within the next 5 years
c) I am likely to liquidate my investment within the next 10 years
d) I am likely to liquidate my investment within the next 20 years
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Investors’ risk tolerance

• Type of investor indicated by the score:

• 10-20 points: Conservative investor: You prefer safety in investment.

• 21-30 points: Moderate investor: You are willing to take some

investment risk.

• 31-40 points: Aggressive investor: You are willing to trade higher risk
for a higher return.

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Conservative Risk Tolerance

• Conservative investors are willing to accept little to no volatility in

their investment portfolios.
• Retirees who have spent decades building a nest egg are unwilling to
allow any type of risk to their principal.
• A conservative investor targets vehicles that are guaranteed and
highly liquid.
• Risk-averse individuals opt for bank certificates of deposit (CDs),
money markets, or Govt. Treasuries for income and preservation of
capital.
• The current yield on a 10-year Treasury bond as of July 1, 2016,
stands at 1.46%, while the fixed deposit stands at 3-3.7% yield.

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Moderate Risk Tolerance

• Moderate investors accept some risk to principal but adopt a

balanced approach with intermediate term time horizons of five to 10
years.
• Combining large-company mutual funds with less volatile bonds and
riskless securities, moderate investors often pursue a 50/50 structure.
• A typical strategy might involve investing half of the portfolio in a
dividend-paying, growth fund such as the Equity Index fund, which
holds average risk.

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Aggressive Risk Tolerance

• Aggressive investors tend to be market-savvy. A deep understanding

of securities and their propensities allows such individuals and
institutional investors to purchase highly volatile instruments, such as
small company stocks that can plummet to zero or options contracts
that can expire worthless.
• While maintaining a base of riskless securities, aggressive investors
reach for maximum returns with maximum risk.
• For example, a favorite hedge fund bet in 2014, SunEdison, a solar
power provider, was estimated to be worth $32 per share by
Greenlight Capital's David Einhorn, who took a $480 million stake in
the company. The stock, after being exposed for duplicitous
accounting practices, sits at 14 cents per share on July 1, 2016.

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Conclusion

• Relationship between investment objective & risk definition

• Risk = the chance that a known set of objectives will not be achieved.
• It is up to the client to explore and find strategies to achieve those
objectives.

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The END

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