The Risks and Returns on Savings and Investments - which is best for you?

One of the cornerstones of a good savings plan is to have a goal in mind. Saving for a rainy day is nice, but how about saving for a home? Saving for a holiday to Europe, or a tropical island? The more specific the goal the more targeted you will be. So do you save or do you invest? Is there a difference?

There are four main assets you can invest in.

• Cash

• Fixed Interest

• Shares

• Property

Depending on the purpose of the investment some assets are more appropriate than others. Diversifying with a combination of the four different assets could be the best plan for you. Or it might not, how do we find this out? We perform a “Risk Profile”.

Risk

When we refer to risk, we are generally referring to one or a combination of the following 3 things happening:

• The chance of losing some or all of your original investment.

• The chance of losing the purchasing power of your original investment, or

• The chance that your balance will move up and down frequently (volatility).

There are essentially four ways to manage risk:

1. Elimination – risk is only eliminated when you avoid investing in assets that experience any of the risks listed above.

2. Control – take action to reduce a poor outcome, such as diversifying your investments.

3. Transfer – transfer the risk to a third party in the form of insurance, there is minimal options of doing this in investing and it comes at a cost, and

4. Retention – take the risk and hope for the best.

Return

Money is invested in the hopes of achieving a positive investment return.  The return is the level of profit from an investment – in other words, the reward for investing.  The return from an investment can come from two sources:

• Income,

• Capital Growth.

Some investments offer only one source of return, for example, Term Deposits provide income in the form of interest, but no capital growth. Whereas a block of land should grow in value but provide no income unless you are able to rent out the use of the land.

Income is:

• Interest received on term deposits

• Rent received from investing in property

• Dividends paid from ownership of shares.

Income from Fixed Interest investments such as Term Deposits is more reliable than income from property or shares as these are not guaranteed.

If an investment sells for more than it cost to purchase, then the excess is called the capital gain (or capital growth).  If an investment sells for less than its original purchase price than the investor has made a capital loss.

Risk-Return Trade-Off

There is a trade-off between risk and return.  The higher return you are chasing, the greater risk you have to take.  However, just investing in a high-risk security does not mean you automatically earn a high rate of return.

Cash

If you need access to your investment within 3 years, your main concern will be to protect your capital.  A high interest savings account is safe and your money will be available when you need it.  They carry little or no risk, have little or no fees and should be easy to access, but not too easy, as we are talking about “Investments”, ie money set aside for a specific purpose so should not be dipped in to for anything other than that specific purpose.  Cash investments will generally only provide a return equivalent to the 90 day bank accepted bills (of exchange), which is often taken as a proxy for the risk-free rate of return.

Fixed Interest

Fixed Interest investments are Term Deposits or Bonds.  They operate the same way, you invest an amount of money for a set term and in return you receive a fixed-interest return (interest or coupon) at maturity.  Term Deposits can be for as little as 1 month and as long as 5 years, whereas Bonds, which are generally invested with corporations and governments are long-term investments, typically 3 to 10 years.

Shares

When you purchase shares, you purchase ownership in a company.  The return on share investments come from two sources:

1. Dividends – these are periodic payments (often semi-annually) made by the company to its shareholders from its current and past earnings.

2. Capital gains – these result from selling the share ate a price above that or which the shares were originally purchased.

Shares are popular in Australia because they provide tax benefits through dividend imputation (franking credits), capital gain discounts and the fact that stamp duty and GST do not apply to shares traded on the ASX.

Apart from returns, shares offer investors financial flexibility and liquidity.  It is relatively cheap and easy to buy and sell shares to meet cash needs as well as to rebalance an investment portfolio.

Property

Investing in property refers to assets, such as residential houses, vacant land and other forms of property including warehouses, offices and apartment buildings.  As a result of generally increasing values and favourable tax treatments, property is a popular investment vehicle.

It can be difficult to control risk through diversification when investing in property due to the large purchase price required. And there are other costs associated with owning property that needs to be taken in to consideration, such as stamp duty, legal fees and ongoing costs such as rates, insurances and maintenance to the property.

Diversification

Diversification is a risk management technique whereby you mix a variety of assets within a portfolio.  The reason behind this technique is that a portfolio of different kinds of assets will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification should enable the investor to achieve a higher expected return with lower risk.  However, there is a point where you have minimized the risk as much as possible.  Research suggests this is once you have combined a maximum of 20 assets in a portfolio.

Diversification is applied on 2 levels.  First, by spreading your portfolio across each of the four asset classes.  Second, by investing in multiple assets within each asset class, for example, you allocate 20% of your portfolio to shares, rather than buying shares in just one company, you buy shares in multiple companies, this reduces the risk of losing all of your money on that one investment.