Investing Money

An Introduction to Investment and Personal Financial Planning

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Risk v Reward

Betting on horses is risky. If your horse wins you can multiply your stake in a few minutes, but if it loses, so is your investment. Holding money as cash on deposit with a bank is extremely low risk. The worst that can happen is the bank could go broke, but if you're in a developed country and the bank was a reputable one the chances are you'll be covered by some sort of compensation scheme. The downside is you won't get rich quick as the rewards - the interest rate payable - will be extremely modest.

In investment terms the risk of an investment is the degree to which its potential rewards fluctuate. In statistical terms its "standard deviation". An investment that might return between -10% and 30% over a period is more risky than one that will return between 5% and 10% over the same period.

In general investments vary in risk along a continuum, and as risk increases, so does the potential reward. The key to developing an investment strategy is to know your own attitude to risk and compare it to any investments you are contemplating making. If an investment is going to keep you awake at night, it isn't for you. Know yourself, and understand your intended investments.

The lowest risk investment is the price-index linked instrument, sometimes issued by governments. While this investment will never make you rich you can guarantee that your investment will at least maintain, and usually improve its actual purchasing power, since funds increase in line with some official price monitoring index.

Next along the scale comes cash deposits and government backed bonds. Whilst capital remains intact with deposits, your returns are subject to the vagaries of interest rate fluctuations and inflation. Government bonds offer the lowest possible risk of default, guaranteed income, and guaranteed repayment on maturity. However, market value will fluctuate with the interest rate and perceptions thereof. And the values guaranteed will vary in their real value according to inflation.

Other bonds vary in risk (and potential rewards) according to the quality of the borrower.

Real estate offers the important safeguard of being real, ie you own a physical asset that will continue to exist regardless of whatever economic booms or busts play havoc with paper assets. Add to that the fixed supply of land ("they ain't making any more of the stuff", Will Rogers) and the fact people will always need somewhere to live and work. However land prices are subject to the same ups and downs as other asset forms. One way to diversify the risk (and hassles) of direct real estate ownership is through a real estate investment trust (REIT) which pools the funds of many investors into ownership and management of numerous properties.

Stocks as an investment class cover a huge portion of the risk-reward spectrum ranging from the huge blue chip mega-corporations to the fledgling penny stock enterprises. The blue chips will most likely never go bust, but they won't double or treble overnight either. Instead the should earn a modest and steadily increasing return for your investment. On the other hand penny stocks can easily double, treble or more. They can just as easily disappear off the map. They should be treated as a gamble. For every winner, expect a few losers. An added risk with these tiddlers is the lack of liquidity. It may not be possible to sell a stock until a buyer is found, and buy/sell spreads may be considerably higher than frequently traded popular stocks. There are of course infinite variations between these two extremes.

Most risky of all (but offering the potential of highest returns) are the various forms of financial derivatives. Many of these are more akin to placing a bet on a horse race than the seemingly considered world of investment, but big gains as possible for a relatively small outlay. Derivatives are certainly not for everyone and can be highly complex. The golden rule is if you don't understand it - fully - don't invest in it.

The effect of risk generally lessens over time. If you need to save money to pay for something in 6 months time a cash savings account is probably your best bet since no one can predict what stock markets might do in this time frame. If, however, you're saving for your retirement in 30 years the stock market is much more attractive since over that time frame with re-investment it will almost certainly beat other types of investment.

Further Reading