Wealth Creation Strategies: Part 2 – Investment Risk and Return

Investment risk and return

Any recommended portfolio or investment strategy needs to be designed around the risk and return philosophy of financial planning.  This requires an understanding of your attitude to risk and return as well as the risk/return level of the various investments available.

Risk of investment relates to the variability of income and capital returns.  The combined result from income and capital movements – i.e. the extent to which actual investment results may vary from expected returns is classed as the ‘risk’ of the investment. Risks to income include:

• Risk of partial or complete loss of income.
• Failure of income to increase as expected.
• Uncertainty about income.

Risks to capital include:

• Risk of partial or complete loss.
• Failure of capital to grow.
• Uncertainty about capital value and doubts about marketability of the investment.

The relationship between risk and the expected return from an investment is fundamental to making appropriate investment decisions.  Investments with high levels of risk usually promise high rates of return, while investments with low risk levels offer low levels of return.

Risk return trade off

The concept of investment return is widely understood.  For example, a 10% per annum return on a capital sum of $100,000 would result in $10,000 increase in value for the year.  However, what exactly is ‘risk?’.

Risk is for the most part unavoidable – in life generally as much as in investing!  When discussing investments, the term ‘risk’ is often expressed as ‘volatility’ or variations in returns. In investment terms, the concept of ‘volatility’ needs to be understood.  It is the measurement of fluctuation in the market values of various asset classes as they rise and fall over time.  The greater the volatility the more rises and falls are recorded by an individual asset class.  The reward for accepting greater volatility is the likely hood of higher investment returns over mid to longer term.   The disadvantage can mean lower returns in the shorter term.  It must also be remembered that it can mean an increase or decrease in capital.

All investments involve some risk.  In general terms the higher the risk, the higher the potential return, or loss.  Conversely the lower the risk the lower the potential return, or loss.  The long-term risk/return trade off between different asset classes is illustrated in the following graph:

Major Sources of Investment Risk

Major sources of investment risk include the following:

Business risk – The risk that the company’s profit margin may be lower than expected due to inefficient management, bad trading policies and changes affecting that industry.

Financial risk – The risk of partial or complete loss of invested capital in the event of the failure of a company or scheme due to an unsound financial structure.

Market risk/Volatility – The risk of capital loss and instability of invested capital, as well as variations in the return from that capital.  It is caused by market cycles and movements in the market.  It can mean the value of capital can vary, both positively and negatively.  These variations can be daily or less frequently.  They can vary significantly or not much at all.  They can be sudden and unexpected or it can be slow and predicted.

Market timing risk – Economists often use economic cycles (ie. the pattern of the economy), to try and predict when a market will rise or fall.  However, this is extremely difficult, as economic cycles are never exactly the same with the same timing.

Economic risk – Risk relating to changes in inflation rates, interest rates, etc.

Political risk – Changes in Government and Government policies.

Interest rate risk/Re-investment risk – Some investors attempt to avoid volatility by investing in fixed rate investments.  They then face the risk that when the investment matures the money may have to be reinvested and interest rates could be significantly lower.  Thus, if they are relying on the interest as income this income could dramatically decrease.

Credit risk – When money is placed with banks and companies through term deposits and debentures they use it in their businesses and pay an interest rate for doing so.  The risk here is the financial ability of those institutions to be able to pay the interest and/or repay the capital on the due date.

Mismatch risk – This means that although a chosen investment may be considered a good investment for certain investors, it may be a poor one if it does not suit the needs and circumstances of the investor.

Inflation risk - Whether inflation is high or low, the cost of goods has always increased over time.  If the chosen investment does not at least grow at the same rate then the real purchasing power of the money is being eroded.

Liquidity risk – Considerable problems can occur if money is required for unforeseen expenses and the investments cannot be turned into cash quickly or without costs.

Legislative risk – Long-term investment strategies can be selected based on current tax laws and regulations.  If these should be changed later then the results required could be badly affected.

Risk of not diversifying – Diversifying investments means spreading the capital across various areas.  Generally speaking these areas are the actual assets, or markets, in which the capital is invested.  If your investment capital is reliant on one asset, or one class of asset, you are exposed to the risk of not diversifying.  By spreading your investment capital amongst various assets and asset classes, should one area do badly, not all the capital is affected.

Opportunities and risks of the main asset classes

There are really four main asset classes in which to invest.  In an ascending order of potential risk they are ‘Cash’, ‘fixed interest’, ‘property’ and ‘shares’.  ‘Cash’ and ‘fixed interest’ provide mainly interest income, although there is some potential growth (and loss) in the ‘fixed interest’ market.  Such money is on loan to the financial institutions.

‘Property’ and ‘shares’ provide rent and dividend income with far more potential growth (or loss), plus some tax benefits.  The money purchases ownership of the asset.  On a risk/return scale, ‘Cash’ would be ranked as low return/low risk and ‘shares’ would be ranked as high potential return/high potential risk.

Cash – Cash can provide certainty of income, guarantee of capital and is usually secure and handy.  However, when you also consider inflation, fees and tax, the returns can be quite low and there is no opportunity for capital growth.  Interest rates will fluctuate depending on Government policy, inflation and global pressures.  Cash provides no tax benefits and is usually good for short-term goals and emergency funds, but over the long-term its purchasing power can diminish and consequently large amounts of money are not usually recommended to be kept in cash.  ‘Credit’, ‘re-investment’, ‘inflation’, ‘mismatch’ and ‘non-diversifying’ are all possible risks of cash investing.

Fixed interest – Fixed interest is a term broadly used to describe investments like bonds, debentures and term deposits. The main characteristic of fixed interest investments is that at the time of investment: the interest rate and the term of the investment are known.  Large-scale investors, like the super scheme on your behalf, usually invest in Government and semi-Government bonds and corporate debentures. Government and semi-Government agencies and other corporations and banks use this money to fund projects of up to 25 years.

In essence, the money is being lent to the institution that, in return, agree to repay interest (regularly) and the principal at the end of the term. Fixed interest investments such as bonds or debentures can be bought and sold and will vary in price depending upon their ‘interest rate’ in comparison to market interest rates at the time. Fixed interest investments are generally less volatile than property and share investments but there is a possibility of growth (or loss) when they are bought or sold prior to the expiry of the original term.  The returns are usually higher than cash and they are often as secure (depending on the financial standing of the institution).  ‘Credit’, “mismatch’, ‘inflation’, ‘re-investment’, and ‘non-diversifying’ are all possible risks of investing in fixed interest.

Property - Property has long been a popular investment in Australia.  Besides residential property there are industrial, commercial and retail properties in which to invest.  Again there are limitations for the individual investor as usually large amounts are needed and it all goes into one property. 

There are substantial costs involved in buying and selling properties and a fair time horizon is required before funds can be accessed due to the time it takes to buy or sell a property.  Rent collection, repairs, refurbishment and dealing with tenants are all time consuming activities.  Property is situated above Cash and Fixed Interest but below Shares on the investment risk scale.  Consideration has to be given to what property, where, what tenants and how much of an investor’s money is in one property.  Generally speaking, income will come from rent and there will be potential growth in value over time.  Overall, property is suited as a long-term investment and can be influenced by inflation and employment levels as well as economic growth and confidence.  ‘Mismatch’, ‘market’, ‘liquidity’ and ‘non-diversifying’ are all possible risks of investing in property.

Shares - Purchasing shares (or equities as they are also known) means owning a part (share) of a company.  It means having a share in the corporation’s future business.  Historically, over the longer term (5 years plus) they are known for keeping ahead of inflation and generally delivered the highest returns of all investment types.  Conversely, as you would expect, they carry the greatest amount of risk and their values can be very volatile with short-term fluctuations in price.  Income will come from dividends (a share of the profits) and there will be potential growth as the company grows financially.  Consideration has to be given as to which industries, which countries and which company(s) – to invest in.

If the shares are in Australian companies then there may be tax advantages through dividend imputation.  This comes as a result of the company issuing dividends to their shareholders from company profits (after tax).  In turn the Australian shareholder receives a credit against their own tax liability for the company tax already paid.  International shares provide dividend income and often higher potential growth.  Of course ‘shares’ can range from the ‘blue-chip’ to speculative resources.

Diversification of assets

A major method of limiting investment risk is to spread the investment capital over a range of different investment asset classes.  It follows the ‘Don’t put all your eggs in the one basket’ investment philosophy, where the individual baskets can include:

• Cash and fixed interest investments.
• Share-market investments (local and overseas).
• Property investments.

The proportional amount invested into each ‘basket’ (ie. the range of diversification of these funds) will depend on the individual investor’s needs and objectives, investment timeframe and attitude towards accepting risk.

Diversification also includes investing into both the local market and overseas markets.  The portfolio’s investment return, therefore, reflects the aggregate performance of the individual asset classes into which the funds are invested.  Diversification provides a protection from risk in that it smoothes the volatility of returns by the individual asset classes.

Spreading your money across different asset classes or markets is one of the best ways to reduce investment risk and improve your chance of achieving consistent returns.

Making wise investment decisions can be a difficult task. There are a number of steps involved: establishing your needs and objectives; including analysis of your risk profile; developing a financial planning strategy; and then selecting products to meet the strategy.

One of the best ways to reduce investment risk, while increasing your chance of a better return on your money over time, is to diversify your investments. Diversification means investing your money in a variety of different market sectors or asset classes.

Investment diversification works on the principle that different asset classes perform better at different times.  Over the past 10 years, most asset classes (or sectors) have been a top performer in at least one year.  Interestingly though, rarely has one asset class been able to achieve this distinction over two consecutive years (international shares over the last three years are a notable exception; refer to Table 1, below).

Table 1:  Best performing asset class for financial years 1997 – 2007

Asset class/portfolio	Australian equities	Overseas equities	Listed property	Australian fixed interest	Overseas fixed interest	Cash
12 months to Apr 97	11.8%	11.0%	19.2%	12.6%	11.8%	7.0%
12 months to Apr 98	15.3%	54.7%	28.2%	14.0%	11.3%	5.3%
12 months to Apr 99	16.5%	14.1%	2.9%	6.9%	9.2%	5.1%
12 months to Apr 00	4.0%	27.5%	3.7%	1.9%	1.9%	5.3%
12 months to Apr 01	10.6%	-4.0%	11.4%	10.3%	9.2%	6.3%
12 months to Apr 02	4.1%	-18.0%	18.2%	4.8%	7.0%	4.7%
12 months to Apr 03	-6.5%	-26.7%	13.3%	9.1%	12.4%	4.9%
12 months to Apr 04	18.0%	12.1%	11.7%	2.6%	4.9%	5.2%
12 months to Apr 05	22.2%	2.1%	21.1%	7.4%	10.3%	5.6%
12 months to Apr 06	37.9%	27.9%	17.7%	4.5%	2.9%	5.7%
12 months to Apr 07	22.2%	6.6%	33.3%	5.0%	6.8%	6.3%

Prevailing economic conditions can impact each of the main investment classes – shares, property, fixed interest and cash – in different ways. At any one time, one investment type will perform better than others. However, knowing which investment type will outperform during a particular period is the difficult part.

Diversifying or spreading your investments across different asset classes can avoid the ‘what if’ questions. ‘What if I’m in the wrong market?’; ‘What if I’m investing in this market at the wrong time?’; ‘What if I could get a better return by investing elsewhere?’. Neglecting to diversify your investments can mean exposing your savings unnecessarily to higher levels of investment risk.

Investing across different fund managers is another way to diversify your investments and reduce the level of risk to which you’re exposed. As various fund managers use different methods or ‘styles’ of investing, this will affect their investment decisions and the types of stocks they select. For example, a manager who uses one particular approach to investing may perform well at the beginning of an economic upswing, whilst another manager may perform better during an economic downturn. By investing with different fund managers in conjunction with diversified asset classes, you can further reduce levels of investment risk and increase your chance of producing more consistent returns over time.

Achieving truly diversified investments can be a difficult task for an individual investor. However, certain investment arrangements exist which can help ensure your investments are diversified regardless of how much you’re investing.

It’s possible to diversify your investments by placing your money in managed investments. A managed investment pools your savings with that of other investors to form an investment fund. As a small part of this large fund, you’re harnessing the buying power of potentially millions of dollars. You can access a broader range of investment opportunities, such as international shares and commercial and residential property, which would be difficult to access on your own.

A managed investment also allows you to maintain a diversified portfolio without the administrative responsibilities normally associated with having a broad spread of investments.

Investment diversification means spreading your funds globally, across all investment categories and with different fund managers. Not only can diversification reduce the level of risk involved with your investments, but it can balance weak performance in one particular asset class with good performance in another.

If you’re concerned about the diversification of your investments, you may need to seek professional assistance to alter your investment spread to suit your personal circumstances and needs. We can help you weigh-up your investment time frame, your approach to investment risk, and your financial needs, arriving at an investment decision that will help your money grow over time without compromising your financial security.

Dollar Cost Averaging

Market timing sounds ideal in theory.  The problem is that few investors, and even few professional fund managers, can accurately predict movements in the share market and, more often than not, market timers sell when the market is low and are out of the market when the inevitable rise occurs. Some people get it right some of the time, but the key point is that for longer-term investors, market timing can expose investors to the very risks they are tyring to avoid.

Statistics show that investors who stay invested and remain focused on the long-term upward trend in the share market will do better.  History tells us that:

• The underlying trends in share markets are positive.
• Markets tend to regain any short-term lost performance.
• Periods immediately prior to and following a market correction are generally characterised by robust performance, magnifying the risks and costs of incorrect market timing.

The greatest risk in attempting to time the market is not the risk of being in the market during a declining market, but the risk of being out of the market at the trough of a decline when sentiment is at its most negative and potential returns are at their most robust.  Consequently, investors with a disciplined investment approach and a focus on long-term wealth creation tend to enjoy better long-term returns than investors who attempt to time the market.

One way you can ensure that you have a disciplined investment approach and that you never miss an opportunity, is to employ a savings principle known as dollar cost averaging.

Dollar cost averaging is a strategy that entails making small investments at regular intervals over a period of time. The period could be months or years and the regular intervals, weeks or months.  In practical terms it takes the guesswork and emotion out of trying to time your entry into the market and allows you to build your investments over time.

It should be noted that dollar cost averaging works best in a falling or a volatile market over a long period of time. Dollar cost averaging will not guarantee a profit (particularly if the investor has to sell at a bad time) and bigger gains are possible by investing a lump sum. However, dollar cost averaging is a highly effective way to avoid the risk of investing at a bad time.

For assistance in helping you create your own wealth creation strategy to help you realise your goals and achieve financial freedom contact us today by either telephone 03 9542 3200 or email blog@freedomfinancialplanning.com.au

WARNING: The information contained on this website is provided in good faith. While the contents are obtained from various sources that are deemed reliable, it is not guaranteed as accurate or complete and should not be relied upon as such. It is recommended that you seek independent, professional advice before implementing any of the suggestions to ensure that it is appropriate to your needs and circumstances.