Professional Investment Services

Insights into Successful Investing - Understand Risk

Don’t avoid or ignore risk – understand it. Then put it to work for you.
It’s human nature to want the highest return possible for the lowest possible risk. But it is very rare to have both.
All investing involves a trade-off between risk and return. Generally, the higher the risk the higher the potential long-term return will be. But the higher the potential for short-term gain, the higher the potential for short-term loss.
What is risk?
In investment terms, risk is an indicator of the potential gain or loss associated with an investment. Risk is often referred to as volatility. The more volatile an investment, the greater the fluctuations in return from month to month or year to year. Below is a check-list of the major risks and some tips on how to deal with them.
Company risk
There are hundreds of factors that can affect a business. There are external factors such as the state of the economy, interest rate levels or the efforts of competitors. There are also internal issues – wage pressure, capital expenditure costs and pressure on the price a company receives for its products. Factors such as these can cause a company’s share price to rise or fall rapidly.
How to manage company risk:
Diversity – By spreading your money across a well-diversified portfolio of shares, you can significantly reduce the risk that a particular company’s health will have a major negative effect on the performance of your overall investment.
Leave it to the experts – Investment professionals are paid to analyse individual companies, industries and the overall economy and to buy and sell shares based on that analysis. They have the time, resources and the skills to do a better job than most individuals.
Market risks
No matter whether you are investing in shares, fixed interest or property, there is a risk the entire market will fall. Generally this is a result of market sentiment turning sour, that is investors believing a particular factor will hurt returns. Broadly this could be caused by two types of risk – economic risk and political risk.
Economic risk involves changes in the rate of economic growth, inflation, unemployment or interest rates which can all have dramatic effects on markets.
Political risk revolves around the ability of the Governments to pass laws that affect the overall economy or regulate a market. Geopolitical events – political instability, internal strife, wars etc – can all have a significant impact on asset prices.
How to manage market, economic and political risk:
Diversity - Returns from property, fixed interest and share markets do not always follow each other. Each asset class can react differently to the prevailing economic conditions. For instance, the fixed interest market, may surge when sharemarkets are falling. By investing in a number of different markets, you reduce the effect a fall in one market has on your overall portfolio.

Currency risk
If you are investing in overseas shares, property or fixed interest securities, you face the risk that changes exchange in currency rates may affect your return.

How to manage currency risk:
Hedge your investment – You can use sophisticated investment products to protect your assets from the effect of moving exchange rates. Many international fund managers hedge their international investments in this way.

Diversify – By investing in Australia as well as overseas markets, you reduce the effect currency movements have on your portfolio.

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Risk and time
One of the most effective ways to reduce risk is to invest over the long-term. Most of the risks described above can have a significant effect on your investments in the short-term. Over time, however, their effect tends to be reduced.
Over time, the return from “growth assets” like shares is generally higher than the return from a low risk investment like cash. If you leave your money in a bank savings account earning a very small interest rate over a longer period of time, you run the risk that your money may “go backwards”- that is, not keep up with inflation.
Source: BT Financial Group – Extract from “Ten Investing Truths”

Insurance Bonds Revisited
Back in the 1980s and early 1990s a popular form of managed investment was the Insurance bond. Insurance bonds were issued by life insurance companies and allowed investors to invest their savings through an insurance policy that, in turn was managed by the professional investment management team working for the life office.
Even though the insurance bond was structured around the concept of a life insurance policy (that is, in the event of the death of the investor, the accumulated proceeds were paid out as a lump sum) they offered investors access to a professionally managed investment portfolio.
In many ways, from an investor’s perspective, insurance bonds are very similar to a unit trust investment, with one significant difference - that being the way in which they are taxed.
The investment earnings and capital gains earned within an insurance bond are taxed in the hands of the insurance company offering the bond, and not directly in the hands of the investor. The tax rate applicable is 30% (although this can be effectively reduced when taking into account the benefit of franking credits, depreciation allowances and other deductions that the life office may be able to claim).
Of course, where an investor invests through a unit trust structure, the tax liability passes back to the investor who is responsible for managing their tax position on a yearly basis.

A number of large life offices still have insurance bond products available to investors. Over recent years the investment options have increased and today, many bonds allow investors to select both sector specific investment options (i.e. shares, property, fixed interest securities and cash) and diversified funds (i.e. a pre-mixed menu of asset classes).
Over the past month there has been a resurgence of activity and interest in insurance bonds as an investment option for investors.
In particular, they appeal to a number of different types of investors including:
• Investors on high marginal tax rates;
• Investors who don’t need to lodge a tax return;
• Investors wishing to have assets by-pass their estate – as an insurance bond is effectively a life insurance policy, one or a number of beneficiaries may be nominated to receive the proceeds of the bond in the event of the death of the investor; and
• People wishing to invest on behalf of children – children under the age of 18 are generally subject to special tax rates on any investment income they earn. Where parents, grandparents, and others wish to set money aside for children, holding those investments in an insurance bond can be tax effective in that the investment earnings are taxed at concessional rates in the hands of the insurance company offering the bond, and not in the hands of the child, their parents or grandparents.
Insurance bonds are not suitable to every person in every situation but there will be occasions when they represent a worthwhile addition to an investor’s portfolio.

Source: Peter Kelly - Professional Investment Services