Following on from your new found appreciation for how efficient our stock markets are, and how you should rather focus on earning a fair return than expecting to do better than everyone else or expecting someone else to do better for you for that matter, we need to now talk about what a fair return might be in the context of what you’re investing in. If you need some reminders as to the kinds of things that you might invest in, catch up on our article on asset classes.
Each asset class has inherent risks associated with it. If you buy shares in a company, the risks are many; poor sales, a down-turn in the global economy, strike action – all would generally lead to a lower share price and a reduction in the value of your shares. For buying shares in a company, accepting that risk requires that you be compensated with a higher expected return.
On the other side of the asset class risk spectrum would be cash. You know that if you put money in your money market unit trust, there is 99.99999% chance it’ll be there the next day, and be worth as much, if not more. You accept little risk when investing in cash like this and accordingly are offered little return in exchange.
So if you bought shares in a company and were told that the long-term prospects for the share price was 6% per annum, that just wouldn’t work. Why would you accept all the risks that are associated with owning shares in a company when the same return can be earned by sitting on a money market unit trust, that is on the lowest end of the risk spectrum?
Same goes for cash. You cannot expect to put your hard-earned cash away and expect it to provide stellar returns for you. You are not taking on enough risk to have the chance to earn higher returns.
This, our WellSpent readers, is the fundamental Risk – Reward payoff.
The reason the Risk – Reward see-saw works the way it does, is largely because markets are efficient (see now why we talked about this first).
If I could put money into cash and earn a very high return, a return that would typically be associated with investing in shares, then everyone would do it. With everyone doing it, the opportunity to profit from such a low risk would be swamped by all our WellSpent readers and the opportunity would soon disappear as more and more people pumped money into this investment.
The contra would be that if investing in shares did not offer the prospect of higher returns, then nobody would take on that risk – why should they? Companies would battle to raise money on capital markets The only way to attract money, would be if they could offer their shareholders the prospect of higher returns.
Understanding now that risk/reward go hand in hand, if you are offered a high return, understand that it comes with accepting a higher degree of risk; it has to. So if you’re lured into taking your emergency fund money out of your money market unit trust and put it into something that might offer you higher returns, then understand that you’re accepting more risk.
Same goes for someone selling you an investment opportunity that pays out 10% per month. This would be an incredibly high reward and should command an incredibly high expectation for risk.
This lack of appreciation for the Risk – Reward payoff can easily manifest when you think that you’re somehow different from the rest of the investing world and start to chase higher returns, not fully appreciating the extra risk you’re taking on. It may not be apparent but it’s there, despite what anybody tells you.
Considering the risk side first, if your friend asks to borrow money and offers you a rate of interest of 7% p.a, this might not be the proper compensation for accepting such risk. Consider that your friend might never pay you and for that, you should expect to be compensated handsomely.
This is why credit card balances and unsecured loans from micro-lenders are so expensive. They are taking a huge risk by lending money to you. They’re accepting a large risk and are requiring compensation that matches the risk.
A home loan carries a cheaper interest cost than a personal loan, but only because its lower risk for the banks. There is a reason the banks take security over your property by way of a mortgage. If you don’t pay them then they take your house. They are de-risking and in turn, charging you less interest .
In an ideal world, there would be no risk, but nobody would ever earn a decent return on any asset class.
In the context of saving for retirement, you will need to accept a certain amount of risk to earn a return that is enough to provide for a real return in the long run. The problem here is that only shares have over the long run, shown the ability to provide that real return that is needed to fully take advantage of compound interest and grow your money.
Putting “risk” and “retirement” in the same sentence, gives most people goose bumps, but accepting and managing risk forms part of all long-term savings. The risk is needed to provide the higher return.
It then really becomes a conversation about managing your risk. This is called diversification. We’ll get around to discussing diversification soon enough, where you’ll learn how the old adage of ‘not putting all your eggs in one basket holds’ true.
If you consider your own appetite for risk, you’ll soon find your favourite asset class. The super risk averse might not even trust a bank enough to deposit their money with them. Theirs is a buried tin in the back garden. We all know what kind of return that will generate!
The super-aggressive and hungry go-getter might be happy for all the risk in the world, if it meant the prospect of earning higher returns. Theirs might be a collection of unit trusts investing only in shares.
Your own risk appetite will to a large extent dictate your investing style. When it comes to taking the plunge and especially when it comes to retirement funding, a financial advisor will guide you to taking on the right amount of risk for your age, personality and investing needs.
You may be thinking that you have found a loophole in the Risk – Reward equation. Let us be the ones to let you down gently.
You will from time to time find companies and investment products that guarantee you a specific return. In the not-to-distant past, there was a company that was advertising an annual return of 19.5% guaranteed. If something is guaranteed, you might think you can disregard the Risk – Reward balance, as where is the risk if the return is guaranteed?
On a good day, getting a return of 19.5% for a year gone by would be worthy of the biggest self-high-five ever. To get a guarantee on that would be astounding.
If a stranger offered to pay you 20% per annum if you loaned him R1 million, chances are you wouldn’t do it. Why? Because the ability of the stranger to repay you both interest and your capital sum back, carries massive risk no matter what rate of interest they’re prepared to pay you. As a borrower, the stranger’s credit worthiness is what you are relying on to sleep at night.
Same goes for a guarantee. If Company X is offering you a guaranteed rate, you need to consider the company making the guarantee. How likely is it that they’ll make good on their guarantee?
I’ll happily accept a guaranteed rate from a large life assurance company, as I know the chances that they’re not going to pay me are miniscule. Having this credit-worthy guarantee does however mean that the rate that they will guarantee me will be lower. See how the Risk – Reward relationship holds true?
If a stranger gives me a guarantee, it’s likely to be worthless, in which case the return they are offering needs to compensate me for the risk I am taking; the risk that I never see them again, or my money.
So when a company starts advertising guaranteed returns of 19.5% you must look at who is offering the guarantee, and is it worth anything. If it’s worth close to nothing, then don’t think of it as a guaranteed return at all. Look for the risk.
Remember that higher risk, generally means higher return, but this has to be qualified.
Just because shares offered higher returns in the past, does not mean they’ll carry on doing this.
The long term does not mean forever.
High risk and reward, comes with volatility.
Taking on more risk in the pursuit of returns, is really just a ticket to the potential for higher returns. Not guaranteed returns. The world cannot guarantee you anything (except death and taxes).