How much investment risk can you take?

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Investment risk is the degree to which your investment will experience volatility and how comfortable you are with this.
Shares for example are far more volatile than cash or fixed interest and so the greater proportion of shares in your portfolio the more volatile it will be. Volatility can include periods of negative returns which can prove distressing to investors.

Most periods of negative returns are followed by extensive periods of positive growth which more than replaces the amount lost. If however you are forced to withdraw money for living expenses during a time of negative growth your capital may be depleted to a point that you can no longer live off growth alone and will be forced to withdraw from a reducing capital base.

If you have sufficient capital however you can continue to withdraw living expenses during the period of negative growth without reducing your capital to the point it can no longer generate enough income to meet your needs.

Essential questions are

• What are your goals and objectives?
• What is your time-frame?
• What are your expenses?
• What are your liquidity requirements?
• What are your age?
• What is your ability to withstand periods of low or negative growth?

What types of risk are there?

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• Market risk.
• Interest rate risk.
• Currency risk.
• Concentration risk.
• Credit risk.
• Reinvestment risk.
• Inflation risk.
• Horizon risk.
• Longevity risk.

Market risk

Market risk is the risk that developments in the wider market will cause the value of the investment to decline. For example the sub-prime crisis caused equity markets throughout the world to decline.

Interest rate risk

A change in interest rates can impact debt investments like bonds. For example if interest rates go up existing bonds offering a lower rate can only be sold at a discount to new buyers.

Currency risk

Currency risk is the risk of losing money because a currency changes in value. For example if you have invested in the US and the Australian dollar increases in value against the US dollar you could lose money even though the value in US dollars has increased.

Liquidity risk.

Liquidity risk is the risk that you may not be able to sell your investment at a fair price or at all. If liquidity requirements force you to sell (sometimes called a “fire sale”, buyers may capitalise on your plight and offer a very low price.

Concentration risk.

This is the risk that all your investments are concentrated in a single investment or one type of investment. For example if all your money is invested in a single share your fortunes are entirely dependent on how it performs.

Credit risk.

Credit risk is the risk that the entity who issued the bond (for example a government or company) will be unable to repay you the money you invested. To reduce this risk you can look at the bonds rating. AAA for example suggests a bond is very low risk .

Inflation risk.

Inflation reduces the buying power of an investment over time. By adjusting for inflation you can see the “real” value of an investment at maturity.

Other risks that may impact are;

Reinvestment risk.

Reinvestment risk is the risk of reinvesting at a lower rate. If for example you own a bond paying 6% and rates drop to 5%, you can only reinvest the income at the lower rate of 5%.

Horizon risk.

Horizon risk is the risk that your horizon is reduced. For example if you are forced to retire 10 years early you will lose out on 10 years of contributions and growth.

Shares

Calculate gains and dividends

Shareholders purchase a “share” of a company which increases or decreases with that company’s fortunes. They also enjoy dividends (if declared) and the tax benefits of franking credits.

Shares are easily traded on the exchange unlike property which many investors see as a valuable feature.

Benefits

Shares offer capital gains, dividends and tax efficiency.

Capital gains

Over the longer term (20 years or more) shares have been the best performing asset. Over shorter periods their performance has been less impressive and negative returns occur regularly.

According to the Russell Investment report over the last 10 years from December 2014, Australian shares only managed 7.1% with Australian fixed income returning 6.5% (see the report above).

Dividends

Dividends are paid out of profits and are only paid if the company decides (at it’s discretion) to pay them.
Company’s pay tax on profits (currently 30%) and to tax dividends as well would mean double taxation. Companies pass a franking credit onto shareholders which represents the tax that has already been paid. If the company passes on the dividends without paying tax then there is no franking credit.

Tax efficiency

Not only do investors benefit from franking they are also able to “gear” the investment by deducting certain costs from the profits. These costs include the costs of borrowing.

Risks of buying shares

Share prices can fall dramatically and take the value of your shareholding with them.

If the company goes into liquidation you are the last to be paid and there may not be enough to pay you.

Investment bonds

Calculate value in 10 yrs and tax for early withdrawal

An investment bond is a “tax-paid” investment where the insurance company has “pre-paid” the tax at up to the corporate tax rate (currently 30%). It is technically an insurance policy and so there must be a life insured and beneficiary.

Advantages of an investment bond are;

• Investors don’t have to declare earnings as long as they do not make a withdrawal within the first 10 years.
• If annual contributions increase at 125% (or less) every year then profits on the additional contributions don’t have to remain invested for 10 years to enjoy the “tax paid” status.
• Investors can withdraw part or all of their funds at any time but some of the withdrawal may be taxed depending on when it is withdrawn.
• There are no contribution caps but if you exceed 125% of the previous year the start date is reset to the year the 125% is exceeded.
• The underlying investments can match the investor’s risk profile.
• If the investor nominates a beneficiary then the proceeds go to that person by-passing the estate and any possible challenge to the deceased’s assets.
• Some insurers offer a guaranteed death benefit.
• Death benefits are paid tax-free regardless if the beneficiary is a dependent or non-dependent.
• The policy can be set up so ownership automatically passes to a child when they reach a certain age.

Disadvantages of an investment bond are;

• The investment is taxed at a relatively high rate (currently 30%)
• Making a withdrawal before 10 years will have a tax consequence as described below.
• Management costs can be relatively high.
• If you do not make a contribution in any of the first 10 years the 10 year term is reset.

Early withdrawal

Year withdrawal made	Tax treatment
Withdrawals within 8 years	100% of the earnings on the investment bond are included in your assessable income and a 30% tax offset applies.
Withdrawals in the 9th year	2/3 of earnings on the investment are included in your assessable income and a 30% tax offset applies.
Withdrawals in the 10th year	1/3 of earnings on the investment are included in your assessable income and a 30% tax offset applies.
Withdrawals after the 10th year	All earnings on the investment are tax free and do not need to be included in your assessable income.

Withdrawal formula

• A = amount withdrawn
• B = bond value before withdrawal
• C = sum of any previous withdrawals
• D = gross contributions
• E = sum of previously assessable amounts

Assessable amount = A/B x [(B+C)-(D+E)]

Investing in Property

Borrowing to buy property

There are many different types of property ownership. For example;

• Direct property
• Global property
• Listed property trusts
• Mortgages
• Managed investments

Direct property

According to the Australian Bureau of Statistics around 70% of homes are occupied by the owner.

Investors can also buy commercial properties such as offices, factories, warehouses etc.

Global property

Global property involves purchasing property outside Australia. This adds the risk/benefits of currency and foreign investment risk.

Listed property trusts

These are pooled property investments divided into units and listed on the stock exchange.

Listed securities allow you to invest in property while enjoying the benefits of diversifying across a range of property types. They carry a medium to high level of risk.

Tax efficiency

Investors are able to “gear” the investment by deducting certain costs from the profits. These costs include the costs of borrowing.

Exchange-Traded Fund (ETF)

An exchange traded fund is a marketable security, traded on the stock market, that tracks an index, commodity, bonds, or a basket of assets like an index fund. Just like shares, an ETF’s price fluctuates constantly as it is bought and sold. This makes the attractive as a “liquid” asset.

The ETF owns the underlying assets and divides them into shares. Investors do not own or have any claim against the underlying assets. They are entitled to a proportion of the proportion of any profits (or losses) and may receive part of the residual value if the fund is liquidated.

Only large authorised financial organisations are allowed to create ETFs who do this by compiling a portfolio of underlying assets and handing it over to a fund in exchange for ETF shares. Similarly for redemption, the institutions return shares to the fund and get the underlying assets. At the end of each day the fund’s underlying holdings are disclosed.

Advantages of an Exchange Traded Funds

• Diversification. The underlying assets could be a diverse range of asset types
• Selling short. You can sell an ETF that you don’t own if you believe its price will decline.
• Margin buying. Paying only the margin and borrowing the rest (if you have a margin account).
• Costs. Costs are generally lower than a fully managed fund.
• Performance. Active fund managers with higher cost structures have a poor record in beating their own benchmark indices. Source: Legalsuper

The Spider

One of the most widely tracked ETFs is the “Spider” trading under the ticker “SPY” which tracks the S&P 500 Index. These were the top 10 sectors (August 2015 – August 2016).

The Spider

Sector	Percentage
Technology	17.46%
Financials	15.51%
Healthcare	14.04%
Consumer Cyclicals	13.52%
Industrials	12.82%
Consumer Non-Cyclicals	10.69%
Energy	7.38%
Utilities	3.58%
Telecommunications	2.93%
Basic Materials	2.06%

Fixed interest

Calculate the value of a bond

Fixed interest investments provide regular income for a specified term with the initial investment repaid at the end.

Fixed interest investments are issued by;

• Corporations.
• Governments.
• States.
• Financial institutions.

Types of fixed interest

• Corporate bonds.
• Government and semi-government bonds .
• Capital notes.
• Debentures.

Benefits of fixed interest

• Regular income.
• Your investment is repaid at the end of the term.
• if interest rates fall you continue to get the higher interest rate. You may also be able to sell the instrument at a premium.

Risks of fixed interest

If the entity issuing the fixed interest instrument goes into liquidation you may lose your entire investment.

The present value of a bond

The present value (PV) of a bond is the amount that would have to be invested today to generate it’s future cash flow. PV is dependent on the timing of the cash flow and the interest rate used to calculate the present value.
As interest rates move up and down the “required rate” changes and impacts on the value of the bond should the bond holder want to sell.

Investing in cash

Cash investments include money in bank accounts, savings accounts and term deposits and can provide stable, low-risk income in the form of regular interest payments.

The main disadvantage of cash is the returns are so low they may not even beat inflation which means the value of your cash investment constantly decreases in real terms.

Cash is an investment for the very risk averse.

Managed funds

Calculate the future value of a managed fund

In a managed fund all money is pooled and managed by the fund manager who invests the money in a range of assets dictated by the overall risk profile of the fund.

Benefits of a managed fund

• Diversification – the fund can invest in a wide range of asset types.
• Expertise – the fund manager usually has substantial expertise and resources to draw on.
• Small investments – managed funds accept small lump sums as well as regular contributions.
• Administration – the fund manager prepares returns that make it easy to complete tax returns.
• Flexibility – most fund managers allow you to monitor your investment and switch to other funds that suit your changing risk profile.
• Buying and selling – you are generally able to cash in your investment at any time.

Risks of a managed fund

• Control. you have no control over which assets are bought or sold.
• Fees. You may be charged higher fees than other investments.
• Expertise. You rely on the expertise of other people.

Active and passive investing

Actively managed funds aim to outperform the market by buying and selling assets.

Passive managers, also known as index funds, buy a portfolio of shares that mimic an index like the all ordinaries index. There is a limited choice of index funds for investors looking to invest directly.
Exchange traded funds (ETFs) are essentially index funds and can be bought and sold on the ASX.

Robo advice

Robo advice removes the adviser and uses an algorithm to choose the best product for the user. Online questions establish the user’s risk profile and that is matched to the most appropriate asset mix.

Robo advice purports to;

• Remove emotion from investment choice.
• Make better investment choices as the algorithm is able to analyse huge amounts of data quicker than a human can.
• Remove conflicted sales where advisers are paid to recommend a product.
• Reduce costs.
• Convenience. Investments can be made from the comfort of the investors home.

Risks of Robo advice

• The “robo” may not ask the right questions or interpret them well. This could leave you with a portfolio that is not suitable.
• Investments are in ETFs (Exchange Traded Funds) which are essentially index funds. There is no attempt to choose individual assets that may outperform the market.
• Does the “robo advice” operate withing the Australian legislation? Do they have an Australian Financial Services License? Did you receive a Financial Services Guide? Did you receive a Product Disclosure Statement?
• What is behind the “robo advice”? What financial backing do they have? What expertise and human talent do they have?

Voice “first” artificial intelligence

Artificial intelligence, including “voice” is part of the “Fourth Industrial Revolution”. Amazon’s “Alexa”, Google’s “Home” and Apple’s “Siri” all harness the growing power of artificial intelligence.

Try Finchat’s skill. If you have an Amazon device like an Echo or simply have the free Alexa app on your phone, add the “finChat” skill.

Currency

See the effect of a change in currency values

Currency risk arises from the change in price of one currency against another.

For example, if you are an Australian investor and you have stocks in the US you will be affected by both the change in the price of the stocks and the change in the value of the Australian dollar against the U.S. dollar.