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Risk and complexity in investments: KISS*

Key questions answered for novice investors

Complexity can be helpful, but it can be confusing too. Photo: Shutterstock

Complexity can be helpful, but it can be confusing too. Photo: Shutterstock

This is part 3 in a series of four articles about questions to ask yourself before investing. In part 1 we discussed how much risk you should assume, while part 2 dealt with ways in which you can diminish your risk.

In the last article, we saw how Malta deals with oil costs by establishing prices ahead of time through hedging agreements (specifically forwards/futures). With some complexity, a small country could purchase a series of derivatives that hedge against fluctuation in energy prices on both ends, limiting the effects of an increase in value but still taking partial advantages of a decrease in value.

Yet complexity can lead to misguided safe assumptions - just look at the collateralised debt obligations and credit default swaps widely accused of having caused the 2007-09 recession. While this may be an exaggeration, comparable to blaming World War II on the existence of tanks, these complex financial instruments did exacerbate negative outcomes.

Moreover complexity can be downright unethical. While in the Middle Ages interest payments were banned by the church, a ‘contractum trinitus’ - three legally separate contracts which created an interest payment when combined - were not. Nowadays, some accuse most Sharia-compliant products to be similarly abusive.

Hence the third question is: How much complexity do you want?

This is not a recommendation to avoid or encourage complexity, but a suggestion to understand the complexity of your financial decisions. If you cannot understand it, maybe it’s not right or maybe you should try to. For example, I have not yet fully grasped how blockchain and hence bitcoin works; nor do I trust the exchanges that trade bitcoins. Hence I am hesitant to buy any bitcoins, despite projections these will grow in value.

Complexity should exist to improve your situation in relation to the questions answered in the earlier articles, but be careful: don't get confused or deceived into a false sense of security.

Dominic Cortis  is a lecturer in actuarial science with the department of mathematics at The University of Leicester where he is also course director for the distance learning program in Actuarial Science. You can get him jealous by tweeting him pictures of the Maltese sea @domcortis

*Keep it simple, stupid

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