Mary Holm: Risk and return go hand in hand

This week and next week, this column will publish excerpts from a small book Mary Holm has written for the Reserve Bank called Upside, downside: A guide to risk for savers and investors. It will be given away free to the public in September. This column will tell you how to get a copy then. Today's excerpts include an overview and an example of one type of risky investor behaviour. Next week we will publish further examples.

Risk is not a dirty word

Every now and then, stories emerge in the news media about investments that have gone horribly wrong. In far more cases, though, the stories don't make the news. One individual or family realises, perhaps with shock, that their savings are worth much less than they expected.

The people involved would have started out the investment confident it was going to work well. They may have been enticed by high projected returns, and perhaps exciting graphs or comforting words from whoever was selling the investment, such as "guarantee" and "secured".

Rest assured, though, that - despite what any adviser, seminar leader, author, sales agent or broker tells you - no investment that is expected to pay high returns has low risk.

The data used in graphs can be carefully selected to give a false impression, or promoters can pick a few successful past investments and present them as typical when they are not. And comforting words can be pretty meaningless if the company that uses them goes bankrupt.

It's common for investors to not fully appreciate the risks they are running.

First, though, an important point: investment risk is not necessarily bad. Higher risk investments tend to bring in higher returns - basically because nobody would be prepared to take on the extra risk if they didn't expect to be rewarded for it. (see The 2 Rs).

Investing in shares, for instance, tends to be riskier than investing in property. And - despite recent history in New Zealand - returns on shares in most countries over most periods are higher than returns on property, which in turn are higher than returns on high-quality bonds.

Note, too, that fairly small differences in returns can make a big difference over a long period. Let's say, for example, that shares have a long-term average annual return of 8 per cent, while for property it's 7 per cent and for bonds it's 6 per cent. Over 30 years:

* $100,000 in shares at 8 per cent would grow to a little more than $1 million.

* $100,000 in property at 7 per cent would grow to just over $800,000.

* $100,000 in bonds at 6 per cent would grow to nearly $600,000.

Investment risk and the returns that tend to go with it, then, can be good for people investing over long periods. In fact, taking too little risk can be harmful. Those who keep their long-term savings in bank term deposits or low-risk KiwiSaver funds will probably end up with a much smaller total than those who take on some investment risk. Sometimes they might even find that, because of inflation, the buying power of their savings decreases over time.

It's crucial, though, to understand the risks you face in an investment. You can avoid or reduce some risks without lowering your expected return, while other risks are unavoidable if you want a higher return.

Knowing about unavoidable risks, you might decide to give the investment a miss, or to modify it. You might, though, decide to forge ahead anyway, while planning what you will do if things go wrong. Planning can make a huge difference to your ability to cope.

In investment, knowledge is power.

This book includes descriptions of various types of risky investment behaviour, and tips on how to avoid or reduce the risk.

Footnote: When we say shares tend to be riskier than property, that's assuming we haven't borrowed to invest in either one.

However, it's common for people to take out a mortgage to invest in property, but not to borrow for share investment. And borrowing increases risk. It's quite possible, therefore, that a mortgaged property investment will come with higher risk and higher expected returns than an ordinary share investment.

The two Rs

Risk and return tend to go hand in hand in investment.

Firstly, let's look at returns - what you get back from an investment. Returns can include interest, dividends or rent. On some investments you can also get capital gains - the difference between what you pay and what you get back when you sell.

The return on investments such as property and shares depends to a considerable extent on what you pay to get in.

If you pay $8 for a share and, over several years, its price rises to $12, your return is 50 per cent plus any dividends. But if you had paid $9, your return would be only 33 per cent plus dividends.

Similarly, if you pay $200,000 for a property and the price rises over time to $300,000, your return is 50 per cent plus rent net of expenses. But if you had paid $250,000, your return would be only 20 per cent plus rent.

The rule: the lower the initial price, the higher the return - everything else being equal. And the higher the initial price, the lower the return.

Okay, so why are high-return investments often risky, and why do risky investments tend to bring in high returns?

With a fixed-interest investment - such as a bond, debenture or term deposit - the company issuing it will always want to pay as little interest as it can.

If it's paying high interest, that's because it's risky, and potential investors won't be willing to take on the risk unless they are compensated with a high return.

With shares or property it's a bit more complex.

If a share was expected to bring in a high return and was regarded as low risk, everyone would want to buy it.

Whenever lots of people want to buy something in short supply - for example, tickets to a concert or sporting event - the price tends to rise. The same with shares. The demand would push up the price to the point where the expected return was no longer high. (Remember our rule: a higher initial price means a lower return.)

But if that share was regarded as risky - perhaps because the business was new and its prospects unknown - fewer people would want to buy. The price would stay low because of the uncertainty, and the expected return would stay high.

Those who buy risky shares are, on average, rewarded with higher returns - although it's important to note the "on average". Some risky shares do extremely well while others bomb out.

The property story is similar. If a certain type of property was seen as high-return but low-risk, demand would push up the price to the point where the return was not particularly high.

But if the property was regarded as risky - perhaps because there was difficulty in finding good tenants in that area - the initial price would stay low, and the expected return high. As with shares, though, some risky properties will do really well while others won't.

What about comparing different types of assets?

In general, over the long term shares pay higher returns than property, which in turn pays higher returns than high-quality bonds. That's because shares are the riskiest, then property.

Consider Typical Company, which has raised some of its funding by issuing bonds and some by issuing shares. Before its shareholders get any dividends, it has to pay interest and repay principal to its bondholders, and also rent on any property it leases.

If you own shares in Typical, there's a bigger chance your investment will perform badly than if you own Typical bonds or lease property to the company. You can also expect the share return to fluctuate much more - doing well some years and badly in others.

On the other hand, if Typical grows healthily over the years, the sky's the limit on your return. And there's a pretty good chance it will grow. Over the long term more listed companies do well than do badly.

Still, shares are quite risky. If most shareholders weren't rewarded for taking on more risk than bondholders and property investors, demand for shares would fall.

That would lower share prices. And - it's that rule again - that would boost returns, bringing people back into the market.

Generally speaking, because of the way market forces work, practically all high-return investments are risky at least over the short term, and all risky investments have high expected returns over the long term - even though some don't fulfil that promise.

In KiwiSaver

Many KiwiSaver providers offer a choice of low, medium and higher risk funds.

The returns on higher risk funds - which hold a larger proportion of shares and often also property - are likely to fluctuate more than on lower risk funds. But we expect their average returns over the long term to be higher.

Risky behaviour: Being overconfident

It's great to invest with confidence. But many people think they are better than they really are at selecting shares or property, or working out when markets are going to rise or fall.

They tend to remember their good investments and give themselves credit for them. The mistakes? Bad luck, of course!

Overconfidence often leads to too little diversification. If you know you're onto a winner, why would you water that down with other shares or property? The answer is that your choice might not win.

Another common result of overconfidence is frequent trading, which can be expensive in terms of fees, commissions, legal costs, sometimes even expensive computer trading programs - which have not been shown to work by independent researchers.

In New Zealand, too, frequent traders must pay tax on their capital gains. This makes a huge difference. If you pay 30 per cent tax on your gains over 20 or 30 years, you might end up with about half what you would have accumulated if you made the same returns untaxed. If you pay 33 per cent tax, it's even worse.

That wouldn't matter so much if you made much higher returns before tax. But there's no evidence to suggest that frequent traders' returns are usually higher than those who buy and hold. In fact, after taking fees and commissions into account, they tend to be lower.

Generally speaking, investors are better off to invest widely and then stick with their choices. And there's a bonus: It takes much less time and effort.

You might miss out

Overconfident share investors tend to be in and out of sharemarkets, trying to avoid the crashes but catch the booms. Such behaviour can be costly.

Let's look at what might have happened to a frequent trader in US shares over the 20 years from January 1992 through December 2011.

If he (it's usually a "he" who trades frequently!) started out with $10,000 and had stayed invested for the whole period, he would have ended up with almost $43,700, says Standard & Poor's.

But if he happened to be out of the market for just the five best days in 20 years - out of a total of more than 5000 trading days - he would have ended up with less than $29,000.

And if he missed the 30 best days - just 30 out of 5000 - he would have ended up with just over $9000. In other words, he would have made a loss.

You could argue that, if he were in and out of the market, he would also miss some of the worst days.

Over the long term, though, sharemarkets trend upwards. There are more good days than bad. You're better to be in the market the whole time.

In KiwiSaver

The trading - or lack of it - is done for you by the managers of your KiwiSaver fund.

Still, some members of KiwiSaver frequently switch their money from one provider or one fund to another, usually chasing whichever one has recently performed well. This is similar to frequent trading. It's usually unsuccessful.

Mary Holm is a freelance journalist, part-time university lecturer, member of the Financial Markets Authority board, director of the Banking Ombudsman Scheme, seminar presenter and bestselling author on personal finance. Her website is www.maryholm.com. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary's advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.