Our lives are governed by many laws. There is the law of the land, common law, the laws of nature, scientific law, and the laws of finance and investing. Apart from the laws enacted by the various levels of government, the other laws have at their heart principles and theories that make sense.
Most people would know of Newton's third law of motion, "To every action there is an equal and opposite reaction". The equivalent law applying in business, finance and investing is, “the level of return is equal to the level of risk”. An example of this is when someone goes for a loan. The greater risk a borrower has in the eyes of the lender the higher the interest rate charged.
In investing, the greater the risk an investment has the greater the expected return. This is why the interest rate you get on a government guaranteed bank account will be less in the long term than the return you should get from investing in more risky investments such as shares.
With investing there is more than just the risk of losing your money, there are many more that the trustees of an SMSF should take into account when formulating their investment strategy.
Different types of risk
This applies to investments such as bonds, debentures and mortgages and can result in income not being paid over the life of the contract, the amount invested not being paid when it is due, or a combination of both.
This affects overseas investments, such as property shares and loans, where their value and return can increase or decrease depending on how the value of the Australian dollar moves in relation to the overseas currency used for the investment.
This risk can work in two ways. An investment portfolio that is not diversified enough, and therefore concentrated in one class of investment or just one investment in each class, can have its return and value adversely affected.
Where someone over diversifies their investments within each asset class the cost of administering the investments can outweigh the benefits of diversification. Also when someone over diversifies by investing in too many managed funds they can end up paying active fund manager fees but end up with investing in a share index.
In times of high inflation the actual return and value of an investment is reduced. The aim of an investment policy is to produce a return that is greater than inflation. If the return matches inflation the investor is no better off. If it is less than inflation they are worse off. Inflation risk is why it is important to have investments that not only produce income in a superannuation fund but that also increase in value.
Interest rate risk
In times of falling interest rates the income that had been planned for to fund pensions can fall short. In a rising interest rate market the value of some fixed interest investments will drop due to them paying an interest rate that is less than what the market is paying.
Where there are not enough investments that can be converted to cash easily a super fund can be forced to sell an investment at a loss to finance pension payments or other liabilities such as tax. Australia's love affair with property as an investment class can have serious consequences for a super fund that is paying a pension. If for some reason income drops, due to a tenant leaving, a pension may have to be stopped as there is insufficient cash to fund it.
This is the risk that people were painfully made aware of during the GFC. If there are large drops in the value of investments at a time when cash is needed by the fund they may have to be sold as a loss.
Market timing risk
Some people think that they can predict when markets are going to increase and when they are going to fall. This can lead to investments being sold too early when values keep rising. It can also lead to large losses when investments are held for too long and markets crash.
There are three factors that can reduce the risks associated with investing.
The first is related to the length of time an investment is held.
The longer an investment is owned the lesser the risk of it reducing in value. Another way of putting this is less risky investments can have a short ownership period while more risky investments need to be owned longer. For example cash is a day to day ownership proposition while shares should be owned for at least 5 years.
The time factor especially helps reduce the risk of market timing. Where a conscious decision is made to buy an investment and hold it for a long period, no matter what the markets are doing, the chances of making a loss is reduced. An old investment saying is, “it is the time you are in the markets that makes the money, not trying to time the markets”.
The second factor that reduces risk is diversification.
Diversification means investing in all 6 different classes of investment, Cash, Fixed Interest, Property, Australian Shares, International Shares and Alternatives, and also diversifying within each investment class.
An example of this is a person who invests $100,000 in one company takes a higher level of risk than a person who invests $10,000 in ten companies. While a person who invests the $100,000 with three fund managers, each with a different investing style investing in 50 different companies, will be diversified the most.
The final factor relates to rebalancing the investment portfolio of a super fund.
Rebalancing an investment portfolio occurs when the value of one investment or an investment asset class increases to a point where it greater than a predetermined percentage holding. When this occurs it makes sense to sell down that investment, or investments within that asset class, and invest in other areas.
A good example of this when some SMSF trustees recognised they were over exposed to share markets and sold down some of their share investments, and reinvested into other areas such as cash, before the full impact of the GFC was felt.
A person's tolerance to investment risk, and how far away they are from receiving a pension from the fund, determines what percentage they should have in each different investment class. Once the upper and lower percentage limits for each investment asset class have been decided they should not be exceeded.
By following this rebalancing principle as different investment classes increase dramatically in value some are sold at a profit, to reduce the percentage holding so it is in line with the investment policy, with the proceeds being invested in the lesser performing investment classes that are often bought at a discount.