Knowing More Part 3: Can You Stomach the Risk?
Anyone who did basic accounting at school or an “Introduction to Business” module at university will be able to tell that an Asset is something that brings value to a company or is seen as something good for a business. They will list things such as buildings, computers, desks, chairs, company cars etc., and they would be 100% correct. However, in the investment world, an Asset or an Asset Class is seen as something a little bit different and, for the purpose of this article, the only principle you need to remember is the cliché “more risk, more return”.
Different Asset Classes make up the different funds in which individuals invest. The weighting of these asset classes will determine whether the fund is low risk or high risk, as each Asset Class has a different risk factor associated with it. The four main Asset Classes we will investigate briefly are direct shares (equities), property, cash, and bonds. We will also look at how this will affect your investments over time.
Equities are direct shares that investors invest into companies that they believe will perform well. They obtain value when the price of the share rises as well as when the company pays a dividend. Equities carry the most risk of the four Asset Classes but also can achieve the highest return. An example would be buying shares in companies like Naspers, MTN, Standard Bank or Mr Price.
The South African Financial Planning Handbook explains it best when it states that the return from property is made up of two elements. The first element of return is the rental income earned on the property. The second element is the increase in the capital value of the property. Investing in property is medium to high risk depending on whether the property increases in value and whether the property owners can find the right tenants to pay rent.
Investing in cash is a complicated explanation which requires a high level of understanding of how money markets work. The most important thing to know for this Asset Class, however, is that it is very low risk and offers lower returns than equities and properties.
Bonds are like cash in that they are boring to explain and yet, complicated. But like cash, bonds offer a lower return than equities and properties but are also lower in risk.
Managers who run the funds will determine how much of each Asset Class will make up the fund and will thus determine the risk of the fund and who the ideal client investing in that fund should be.
The graph below shows the expected risk and real return of each Asset Class:
The table below shows the return of each Asset Class in that respective year.
What must be noted above is the number of times there has been a negative return for each Asset Class as well as what that return is.
The graph below shows what the expected risk and return of a low risk fund is. This fund will have a higher weighting of cash and bonds (low risk) compared to equities and properties. To interpret the graph below, in any one year the investor can expect a maximum of 17.2% return or a maximum -2.4% return. As it can be seen, the chances of getting a negative return greatly diminishes and this is due to it being a low risk fund.
The graph below now shows a fund with a greater weighting of equites and property (high risk). It must be noted how the expected returns are higher, but as mentioned, with more risk comes higher returns and that is evident in the graph.
To summarise, Asset Classes have different expected real returns with different risk factors. Everyone is different with some being able to handle high risk while others can’t and are happy with the lower returns that lower risk funds provide. One thing is evident: the longer you stay invested, the higher the chance you’ll see high returns.
The question remains, can you stomach it?
“If you take no risk you must expect a low return. Just don’t let anyone fool you into thinking you can get a high return with low risk.”- Paul Clitheroe.
By: AN Blumberg
BCom (Hons), PostGrad Diploma: Financial Planning