Monday, 28 May 2012

Risk and Reward - Revisited

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Risk and reward are the two sides of the investment decision - accompanied by the emotions of fear and greed. Broadly speaking, rewards - in terms of the rate of return that you can obtain - will increase with risk, as the individual investors will usually seek a risk premium.
So, as well as looking for good returns, you need to understand what risks you are taking with your money when investing. Only you know how much risk you are comfortable with - but if you are not fully aware of the risks you could be making the wrong investment decisions.


Risks and asset class

As a rough guide, the investment types considered in the DIY Income Investor approach include (see the Income Pyramid):
  • cash deposits: as safe as the bank (in the UK now generally guaranteed up to £85k for each individual UK banking organisation)
  • ETFs: diversified holdings means any risk is spread (however, there may be other risks specific to the particular ETF)
  • government loans/bonds (bonds or 'gilts'): one of the safest investments, as they are guaranteed by the government
  • shares: there is no guarantee against the company stopping or reducing dividends or going bust
  • corporate bonds and other fixed-income investments: again, although the rate of return is usually fixed for the life of the security, there is no guarantee against failure of the issuing institution 

There are also other, more subtle risks to the performance of your assets:
  • With fixed-interest investments there is a risk that inflation may increase, which would result in a lower resale value of your fixed-interest assets and lower real (i.e. inflation-adjusted) returns
  • With shares, the market value may fall, due to market cycles or due to market dissatisfaction with the company's performance.

The impact of these risks will depend on the time-frame or time-horizon that you are willing to consider. Usually, for the more risky asset classes, you should be prepared to leave the assets invested for 3-5 years - or more to allow for the possible fluctuations in value.

Reducing risks

For the DIY Income Investor there are two main types of risk: loss in capital value (or resale value) and loss of income (meaning the yield falls). Asset classes differ in their risk profile between the two types of risk. For example, reductions in a company's dividend usually results in a falling share price as well; the issuers of some fixed-income investments (such as preference shares or PIBS) can stop dividend or coupon payments, whilst with corporate bonds the income is usually fixed for life - the maturity of the security or the failure of the issuer!

Risk of loss of capital and income can be reduced by:
  • investing only in very safe investments, which might limit the overall rate of return of your portfolio - for example, selecting dividend shares of only larger companies (e.g. FTSE 100 in the UK or Fortune 500 in the US) or choose fixed-income securities from well-capitalised and profitable companies or banks
  • investing in a range of different asset classes
  • do your homework and look at the likely future prospects of any company or bank in which  you are thinking of investing
  • keep an eye on the likely future direction of inflation
  • using government-approved savings/retirement accounts: e.g. holdings in ISAs and SIPPs in the UK are usually held in trust, and would not be affected by a failure of the broker ; IRAs in the US are usually guaranteed up to $1 million
  • diversifying within asset classes, particularly for the more risky assets such as shares and corporate bonds; this is easier to do with shares than corporate bonds, as the latter usually must usually be purchased in large chunks (e.g. 10,000 units)

Rewards


The rewards, again, are of two main types: increased income and increased capital value. As with the risks, not all investments have the same profile of rewards:
  • cash deposits will usually be fixed-rate: meaning that there is no additional capital or income growth possible (instead, inflation is your No. 1 enemy) - target potential yield (UK) 4-5%
  • government bonds and corporate bonds similarly have a fixed coupon, although the price fluctuates, meaning you can buy or sell before the maturity date (hopefully making a capital gain) - target potential yield: UK perpetual gilts (4-5%); corporate bonds: 5-7% for the mainstream, although higher for more risky issues
  • dividend shares are the most 'uncertain', in the sense that the price and dividend can change quickly - target potential yield: (UK FTSE) 4-7%, although higher yields are available for more risky shares
  • other 'hybrid' securities such as , PIBS, etc. will have specific reward profiles; for example, preference shares have characteristics similar to dividend shares and corporate bonds but may have specific conditions attached; PIBS are in some ways similar, although with often more complex follow-on returns if they are not 'called' at maturity - target potential yield: up to 10% for the more risky ones (as long as you have done your homework)
Your worst enemy

Paradoxically, you are your own greatest enemy when investing - or rather your emotions are. We are hard-wired emotionally in a way that does not help to make good investment decisions:
  • an urge to sell assets that have increased in value (in case the opportunity goes away)
  • a reluctance to sell assets that have fallen in value (and admit that you have made a mistake)
  • unreasonably expectations
  • impatience
  • tendency to 'fiddle' with investments (i.e. unnecessary buying and selling)
  • and finally - a lack of understanding of potential risks

Going the DIY route means that, while you may not avoid these common investment faults, you should be better informed about them.  reckon that the more you learn, the more cautious you will become! And the DIY Income Investor approach, based on the Income Pyramid, is inherently cautious. However, you may choose to use part of your portfolio for deliberately more risky rewards - for example, some of the highest yields available to private investors are returns are for slightly 'risky' fixed income securities (see the Portfolio above) - whilst failures are very infrequent.


I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

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