Investment Fundamentals

Risk & Return

Understanding risk & return

Background

For SMSF investors, one of the most important concepts to understand is the relationship between risk and return, and how this relationship is affected by time.

To begin with, lets look at what both these terms actually mean.

Risk

There are many definitions of risk, however the one we think most investors identify with is simply the risk that an investment does not go to plan and they experience a loss on some or all of their capital. It can also include failure to provide income as expected, or opportunity cost – i.e. the loss of opportunity to take advantage of other investments.

A key point here is that while all investments carry at least some sort of risk, the actual amount of risk varies considerably based on the type of asset. For some it is high, whilst for others it can be very low.

Return

The return on an investment is simply the amount that it may earn (or lose) via either income (interest, dividends etc) or increase/decrease in the value of the asset known as capital gains / losses, or both. Returns are often expressed as a percentage. For example, if a term deposit with an advertised interest rate of 2%pa is held for a year, then it is said to have made a 1 year return of 2%.

The risk - return relationship

Risk and return are inextricably linked.

As a general rule, investments that have the highest potential for gains also carry the highest level of risk. These are generally known as “Growth assets” (you may also see them sometimes referred to as “Risk assets”).

The most common examples for SMSFs are Australian shares, international shares, and property trusts. Less common are commodities, collectibles, and alternatives (such as hedge funds).

Conversely, those investments that carry lower risk will also generally offer a lower return potential. These are often described as “Defensive assets”.

These are assets that exhibit defensive, income producing characteristics such as longer dated Government bonds, corporate bonds, managed bond funds & ETFs, and other higher quality debt securities, however they do have some capital price movement (up and down) and carry at least some capital risk. For those with a fixed rate, their price is often inversely related to the direction of interest rates.

A subset of defensive assets are those with low to no volatility and are Government guaranteed (subject to limits) such as short dated Government bonds, and Government guaranteed term deposits and cash. In other words, these assets have no chance of permanent capital loss, subject to the Government not defaulting on their debt obligations. These can also be known as “Risk free assets”. These assets have the highest certainty of a positive return, however they also have the lowest long term return potential, especially in this era of ultra low interest rates.

Different risk levels within each asset type

We’ve just illustrated that there is a different risk and return trade off between different types of investments (or asset classes). But it doesn’t end there. Taken a step further, we can also see that there are also different levels of risk within each asset class.

Lets take a look at Australian shares for example.

On the one hand, consider a small speculative mining exploration company. If its exploration efforts are successful, then large price gains in the stock may follow. However, if it runs out of money and goes bust, the investor is left with nothing to show for their investment, with no chance of recovery. This type of asset is what many may refer to as a “highly risky” or “speculative” asset. That is, it’s a bit of an all-or-nothing bet with very high levels of uncertainty.

On the other hand, consider another mining stock, but this time it’s a large established business. Given it’s large size, long history, strong financial position, and ongoing revenue of the businesses, the probability of it going out of business in the immediate future is much lower. These are often known as “investment grade” assets, where the risk element is much lower than in the small miner example above.

As a research house, our default position is that for the vast majority of investors, especially for SMSFs that are approaching retirement, speculative assets are not appropriate – or at the very least, should be kept to a very small percentage of an investor’s overall portfolio. Most investors should certainly stick mostly (or totally) to investment grade assets, and those with a high research rating.

In the next article, we’ll look at understanding your risk tolerance, or risk profile, and how this dictates how you invest for your financial goals.

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