THE RISK VERSUS REWARD HIERARCHY

21 March 2017


A Firstline Securities Limited Blog by: Jody Hernandez

Generally speaking, you may need to consider accepting more risk if you want to pursue higher returns. If you decide to seek those potentially higher returns, you face the possibility of greater losses, including some or even all of your investment.

The longer you invest, the more time that riskier investments, such as equities, have to recover from any falls. Bear in mind, however, that long-term investing does not guarantee that you will meet your investment objectives.

Based on this historic performance, investment professionals tend to rate the different types of investments according to a risk/return hierarchy. This generally means that if you want greater rewards, you may need to accept greater risk.

LET’S TAKE A LOOK AT THE MOST COMMON TYPE OF INVESTMENTS IN MORE DETAIL!

Cash and Cash Equivalents

Cash is generally on deposit at financial institutions such as banks and credit unions and earns interest.  Also included in this asset class are short-term debts and securities sold on the money markets—which are known as money market instruments.  These have maturities ranging from one day to one year and are extremely liquid. Treasury bills, federal agency notes, certificates of deposit (CDs), eurodollar deposits, commercial paper, bankers’ acceptances, and repurchase agreements are examples of these instruments. The suppliers of funds for money market instruments are institutions and individuals with a preference for the highest liquidity and the lowest risk.

This is considered the safest asset; however, its value can be eroded in real terms due to inflation.

Bonds

In simple terms, bonds, or fixed interest securities are loans to governments and companies (corporate Bonds). These bonds are designed to pay interest over a fixed term with the original loan being repaid at the end of this term.  The level of risk depends on the credit worthiness of the government issuing the bond. Companies must pay interest on the bonds before paying any dividends to shareholders and if a company is wound up, the bond holders must be paid before shareholders, this is why bonds are considered to be a lower risk investment that other asset classes such as equity in a business. Different types of bonds vary greatly in their risk profile, although government bonds are considered one of the least risky investments. Most government bonds, and some corporate bonds, can be traded on the bond market which gives them some level of liquidity and therefore further reduces the risk.

Pooled Funds/Mutual  Funds

Pooled or mutual funds are a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by money managers, who invest the fund’s capital and attempt to produce capital gains and income for the fund’s investors. The level of risk will depend on which asset types are held within the fund and the level of diversification across these asset types. These funds can benefit from the ability to invest in a wide range of asset types or funds and the expertise of a fund manager to determine how much to allocate to each.

They benefit from diversification within each asset type and some can invest in various asset types such as shares, bonds and property and therefore carry less risk than investing in a single asset.

Property

This can include your own house, or owning rented property as well as pooled funds investing in commercial property i.e. property rented out to companies, offices, warehouses and factories etc. Returns are generated from the increase in property value and rented income. Generally the risk is high due to the large initial capital needed to purchase property, and there’s a limited market for commercial property, and it’s more time consuming to buy and sell such properties reducing its liquidity. Properties can fall in value and rental income may fall or cease if a property isn’t occupied.

Equities

Equities, sometimes called stocks or shares, represent ownership in a company.  Shares are more volatile and so carry more risk than cash bonds and property.  Equities offer the potential for higher returns, although with higher risk. They can be affected by a number of factors including the financial stability of the issuing company, economic outlook, political change, war, acts of terrorism etc.

Returns are generated by income paid as dividends and potential growth of capital.

Commodities

Commodities are physical goods like gold, oil and crops. There can be a high degree of fluctuation in the prices of these commodities and therefore a higher degree of risk than equities. Values can be affected by unpredictable events such as weather and natural disasters as well as political situations, war, over-supply or technology changes. Commodity prices can move in different directions to shares and fixed interest securities, which may help smooth returns when included in a diversified portfolio of assets.

Diversification

We have all heard the saying, “don’t put all your eggs in one basket ‘” and when we talk about investment the term diversification is normally used. Diversifying your investment across multiple asset classes can help to spread your risk: the losses of one asset class could be offset with the gains of another.

Whatever your attitude towards risk, a degree of diversification is sensible to help meet your long-term investment needs.

 “Risk comes from not knowing what you’re doing.” 

-Warren Buffet

This is why its important to be aware of where your investments or your potential investments are on the hierarchy of risk.

 

CLOSING THOUGHTS

Firstline Securities Limited offers comprehensive coverage of local and international markets with a bias for the energy sector. Firstline offers a number of unique opportunities to put surplus cash to work either as your asset manager or investment advisor. Please contact us for more details at info@firstlinesecurities.com or at 868.628.1175. We can discuss your investment needs in detail and craft a portfolio that makes sense for you. We look forward to hearing from you!

CREDITS:

-Investor.vanguard.com

-Investopedia.com

-TheBalance.com

 

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