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Risky investments: is the game worth the candle?

Monday, September 20, 2021

Every novice investor should know what the risks are and how to work with them.

Startup Jedi

We talk to startups and investors, you get the value.

Even if you are just getting started with investments, you probably know there are risks involved. Many people are afraid of losing all the money they’ve been saving for several years and find all types of investment too dangerous. But the risks actually vary from being less than the chance of your money disappearing without a trace from your salary card, to  a 1 in 10 chance of making a profit. What matters is that you choose the degree of risk yourself. Thus, every novice investor should know what the risks are and how to work with them, what risky investments are and how the risk level is related to profitability. And this is exactly what we are going to talk about today!

What are investment risks? Risks and profitability

The definition of investment risks is obscenely simple: risk is the probability of partial or complete loss of funds invested. Different types of investment involve different risks. For example, when investing in real estate, one of the common risks is a drop in the cost of housing in a given place, which could happen due to the construction of a new highway, a large unfinished building nearby, deterioration of infrastructure, poor environment, etc.

When investing in shares, one of the main risks is a drop in the company's value on the stock exchange, and as a result, a decrease in the value of shares. When opening a term deposit in a bank, risk is a situation in which you need to withdraw part of the funds and lose a lot of profit on interest. The risks are very different, and it is important to know all the options in the chosen type of investment.

Risks in investments are directly related to profitability. The more risky the type of investment, the more income you can get —  and vice versa. A bank deposit is perhaps the most reliable type of investment. Even if the bank shuts down, your deposit is protected by a deposit insurance agency. Yet, the percentage of profit here is not that big either - about 5-7%, which is barely enough to overcome inflation (if we are talking about a deposit opened in the CIS countries).

Venture investments are perhaps the most risky and dangerous type of investment. According to statistics, only 1 in 10 venture capitalists return their investments in the project. But the profit here can be fantastic. The people who invested $250,000 in WhatsApp and became co-owners of the company split $22B among themselves in 2014 after the purchase of the service by Facebook. If the project "takes off" —  the investor's profit is thousands of percent.

The most reliable types of investments are:

Bank deposits.
  • Bonds (especially government bonds).

  • Precious metals.

The most risky and dangerous types of investments:

  • Forex.

  • Cryptocurrency.

  • Startups.

  • Venture investments.

How risky your investment in stocks and real estate will be depends on many specific factors.

And there is good and bad news here. The bad news is: there is always risk in investments, at least minimal. And the good news is: you can manage risks, reducing them even in complex, highly profitable types of investments. And in order to manage risks, you need to know what they are.

Types of investment risks and how to reduce them

All the many types of risks can be divided into two broad categories

System — when not only your specific investment is at risk, but also the entire given type of investment.

Personal — risks related to specific people and circumstances.

Systemic risks

Inflation

One of the "basic" risks that is always present is inflation, even the least risky type of investment —  a bank deposit —  will not do without it. Inflation appears when the money supply in the state exceeds the commodity supply. There is a surplus of funds, money becomes cheaper and prices rise. In different countries, the percentage of inflation is different. Thus, in developed European countries such as Germany, Switzerland or Netherlands inflation is 0.5-1%. In developing countries, inflation rates tend to be higher. In Russia, the average inflation rate during the year is 4% to 8%. Accordingly, the profitability of investments should not be less than this, otherwise inflation will simply eat up all profits (however, in this case, investing is more profitable than just keeping money on the card).

How to reduce risks:

  • Keep money in a deposit with an interest rate higher than inflation.

  • Keep some of the funds in the safest foreign currency or, alternatively, open a multi currency account.

  • Diversify your funds: build a portfolio of stocks of large companies and government bonds and use different types of investments. So some part of the investment in terms of income will definitely exceed inflation.

  • Always compare interest on investments with inflation.

Depreciation of currency

Currency rates change frequently and this can have a significant impact on the return on your investment. The exchange rate is influenced by many factors: big politics, the international situation, the key rate of the central bank, and so on.

Let’s have a look at a classic example. You buy shares of an American company in dollars, the shares rise in price, the company is doing well, but after a year the dollar falls against the ruble, and now you are no longer earning, but losing money.

The most dangerous option is a sharp jump in currencies. A striking example is “Black Tuesday” in December 2014, when the ruble collapsed in Russia. The dollar rose against the ruble by 10% and continued to grow throughout December, and the main victims of the situation were people who invested in mortgages in foreign currency. For some of them, the amount of payments became unaffordable overnight.

How to reduce risks:       

  • Buy assets in different currencies / open multi-currency deposits.

  • Keep some of the money in dollars, euros and other stable currencies (or precious metals).

Market risks

This risk here is mainly associated with a deterioration in the position of companies in the market, which inevitably leads to a fall in stocks. There can be many reasons, like a change in management, an outdated business model, a loss-making project, a risky step that was criticized in the media, a bold statement by the management ... Even the most experienced investors cannot predict what’s going to happen to a company's shares on the market.

How to reduce risks:

  • Do not invest all your savings in shares of one company.

  • Acquire a portfolio of stocks of different companies from different industries, choose large companies with a good reputation, do not get involved in risky industries and projects.

  • Analyze a company before acquiring shares: check out its history, structure, business model, find out information on profit growth and debt.

  • Focus on highly resilient industries: online retail, oil and gas, pharmaceuticals.

Low liquidity risk

To put it simply, liquid means “convertible into money”. An asset that can be sold quickly at a market price is considered liquid. The risk of low liquidity is that you will not be able to quickly sell your assets if necessary (or you can, but at a very low price). This is a big risk for real estate investments. If you urgently need to sell an apartment, you are unlikely to quickly find a buyer at a bargain price. Selling real estate to the first person you meet is an extremely risky plan.

How to reduce risks: 

  • Assess the liquidity of each investment risk in advance and build an appropriate strategy.

  • Keep an airbag in case of unforeseen expenses in highly liquid types of investments: deposits, bonds and shares of reliable companies.

Unpredictable risks

These include all risks that are difficult to predict, and whose impact on the economy is significant, like wars, geopolitical problems, natural disasters, coups and revolutions. Remember the coronavirus pandemic that has irrevocably changed the economy? Some industries are in deep decline, while others, on the contrary, have been given an unprecedented impetus to development.

How to reduce risks: 

  • Keep your savings in different assets —  different types of investments, currencies, industries.

  • If possible, invest in real estate and precious metals, these assets remain valuable regardless of the changes in currency exchange rates.

  • Be prepared for anything.

Private risks

Operational risks

Operational risks arise when the entity to whom you have entrusted your funds is in breach of its obligations. For example, you decided to buy shares of foreign companies through a broker, but they turned out to be a fraud. Perhaps this is the risk that most of all depends on the investor themselves. You need to choose a company with a good reputation and have everything legally secured. 

How to reduce risks: 

  • Thoroughly check all companies with which you intend to interact as an investor in advance.

  • Do not get involved with “gray” and “black” fraudulent schemes. It is a dangerous path that more often leads to legal problems than profit.

  • Seek advice on specific brokers / companies / individuals from an experienced investor.

  • Cooperate with large companies with a transparent work scheme and a positive reputation, avoid risky options with an ambiguous reputation.

  • Make sure you have all the legal agreements and obligations.

Credit risks

This risk arises when a company cannot close its debt obligations, which, in the worst case, can lead to bankruptcy and liquidation of the company.

How to reduce risks: 

  • Form an investment portfolio not only from stocks, but from government bonds.

  • Do not invest all of your funds in one company's stock. It is too risky.

  • Carefully analyze the history, reputation and financial position of the company before purchasing its shares.

  • Acquire shares of several large companies from different spheres and industries.

Business risks

Business risks arise due to problems in the activities of the company: poor management, a series of unsuccessful decisions or the key employees quitting. If a company's business goes badly, its shares will drop in value. And in the worst case, the company will not be able to pay off its obligations, adding the credit risks. It is seemingly impossible to reduce risks in this situation. After all, you are a minority shareholder, and you have no real influence on the management of the company. But the risk will be significantly reduced if you do not put all your eggs in one basket. 

How to reduce risks: 

  • Do not invest all of your funds in one company's stock. It is an extremely dangerous move.

  • Examine unbiased information about the business model, managers, investors of the company, its revenues, profits and debt obligations.

  • Form a portfolio of stocks of different companies in different areas or purchase an ETF (Exchange Traded Fund).

  • Not investing in new IPOs is a risky plan, unless you are a startup expert.

Venture investing: Venture Capital World Leaders 

Venture investment is one of the most profitable and risky types of investments. Even the very name venture comes from the word "risk, risky business." This type of investment seems to be a kind of magic from the world of billionaires who make fateful decisions every minute, launch global projects, get involved in risky adventures, always win and conclude ten digit deals. In fact, everything is much more prosaic: yes, the entry threshold is high here, but it starts from thousands of dollars, not millions. Another thing is that this risky and dangerous activity requires courage, experience, knowledge ... and luck. How does it all work?

A venture capital fund invests in a company at the level of an idea. More often than not, startup teams themselves are actively looking for investors, large funds say no to dozens of people willing to get investments for their project and change the world daily. In order to reduce risks, investments are issued in several stages (rounds). The most risky first stage of the Pre-seed is a small investment to test the idea at the MVP level. Seed is the next round for the release of the first batch of the product and analysis of its relevance "in field conditions".

Real investments begin when the product has shown its viability and begins to consistently receive first sales. In each next round, the venture fund allocates investments for the expansion and growth of the company. The product is already starting to make a profit, investments are becoming less risky. The last round of investments is given to the company to enter the IPO —  then, if the company's shares are bought and rise in price, the venture fund can recoup its investment tenfold or a hundredfold. Sometimes the profit is  a thousand or more times higher than the investment amount. This was the case with WhatsApp, described at the beginning of the article, or Twitter, where $ 57 million in investments turned into a company worth $13B.

How can you become a venture investor?

Invest in a venture capital fund. You invest (the entry threshold starts at $10,000), and the venture fund selects projects and distributes investments between them. At the exit, you get the profit minus the commission to the fund. Some venture capital funds provide for the possibility of joint investment, when several investors with less capital can invest in one project.

Establish your own venture fund. This method is suitable for very wealthy people with successful experience in both creating startups and venture capital investments. If this is not the case, it is an overly dangerous and difficult option. For an experienced investor, owning your own fund is an opportunity to control the companies where funds are invested, increasing the chances of their success, as well as to set their own rules in choosing companies and distributing investments.

Become a business angel. Many successful businessmen and investors do not rely on venture funds and do not create their own, but invest in one or several projects instead. Moreover, they invest not just money, but also their time, expertise and connections. For a startup team, a business angel becomes an investor, a mentor and expert all rolled into one.

Here are the Top 10 Venture Funds in the World, according to a study by Red Herring:

  1. Accel Partners

  2. SoftBank

  3. Index Ventures

  4. Sequoia Capital

  5. Kleiner Perkins Caufield & Byers

  6. DCM

  7. Insight Venture Partners

  8. Draper Fisher Jurveston

  9. Sofinnova Partners

  10. Matrix Partners

Venture investments are about the 100th floor of a huge skyscraper called "investments”. To become a successful venture investor, you need to acquire tremendous experience and knowledge in this area. A big investment journey begins from the first floors, and how risky it will be depends both on you and on a thoughtful risk analysis for each investment operation. But nothing is impossible. As they say, the road will be mastered by the walking one.

Good luck in your investment projects!

20 Sep 2021

 

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