Understanding Financial Risk - Part 2

Financial Risk

When we talk about particular asset classes, we refer to a group of investments that fall into the main categories discussed below. You will note that each asset class has different risk characteristics.


This blog is the second in a three-part series explaining Financial Risk.  In this article, we will discuss asset classes that may affect your financial situation. Stay tuned for our next article to learn more about financial risk.


Asset Classes

When we talk about particular asset classes, we refer to a group of investments that fall into the main categories discussed below. You will note that each asset class has different risk characteristics.

Defensive and growth assets

Investments that have the primary aim of providing the investor with a reasonably secure and safe income are known as defensive assets. Defensive assets include cash and fixed interest. Investments that have a price that tends to increase over time are known as growth assets. Growth assets include both direct and listed property, and shares, and are considered to be higher risk.

Cash

Cash refers to those assets than can be readily converted to physical currency. It includes physical notes and coins, cash management accounts, term deposits, and bank bills with a maturity of 90 days or less. Your cash:

  • returns are known ahead of time, or sit within a very small band of possible returns;
  • has a very high liquidity; and
  • has very low volatility

Fixed interest investments

Fixed interest investments are those that provide regular, pre-determined interest payments. They are sometimes referred to as debt because these investments are effectively a loan to the issuing organisation. Fixed interest includes corporate and government bonds, debentures and notes. Fixed interest investments:

  • Have interest payments that are generally known ahead of time, and are normally slightly higher than cash;
  • Have a relatively low volatility. The price of fixed interest investments are affected by factors such as the central bank’s target interest rate, date to maturity and investor demand;
  • Have varying levels of liquidity. Some widely held corporate bonds are traded every day on the Australian Securities Exchange. Some government bonds can be bought and sold through the Reserve Bank of Australia. However, some fixed interest contracts cannot be traded and must be held until maturity; and
  • Carry some default risk. While there may be little risk of the Commonwealth of Australia defaulting on its obligations, companies can collapse and the payment of interest and/or capital is not completely guaranteed.

Property

Also known as real estate, property is purchased for its higher potential return, including its rental income, and prospects for capital appreciation over time. As we recommend both direct and listed property in clients’ portfolios (when and where appropriate), it is useful to outline the distinction.

Your investment property or direct property:

  • Will tend not to be very liquid. It can take some weeks, months or even years to realise the value of your property at the price you are after;
  • Would not appear to have a high volatility, because it is not valued every day. You won’t be able to ascertain its value with any certainty until the day you sell; and
  • Comes with risks such as tenant damage, default on rental payments, interest rate risks (if geared), market timing risk and the need for maintenance or renovations.

Listed property is also known as a Real Estate Investment Trust (REIT, or A-REIT in Australia). A range of underlying properties are bundled within a trust, and the total assets are divided into ‘units’ which are typically bought and sold on the sharemarket. REITs can be specialised in sectors (mainly retail, commercial/office, industrial or leisure) or diversified across property sectors. REITs:

  • Tend to be relatively liquid, depending on the size of the underlying pool of assets;
  • Can appear to be more volatile than the underlying portfolio of property assets as they are traded on a market; and
  • May trade at a discount or premium to the underlying value of the property.

In 2008/09 some REITs with large borrowings suffered significant price declines during the credit crisis when they were unable to refinance their loans.

Unlisted property can be found as a portfolio of direct assets within a managed fund (defined below) or part of an overall portfolio such as in a large superannuation fund. A small number of investors can also form a property syndicate to collectively invest directly in property. Unlisted property:

  • Can be difficult to value accurately on an ongoing basis. Individual properties are valued periodically, typically on an annual basis. Because of this valuation process, there can be a ‘lag’ between the actual change in value of the underlying properties and the value given to the portfolio as a whole or the unit price where unitised; and
  • Can be very illiquid. Large individual properties can be difficult to market and sell. In 1994 and again in 2008 and 2009 when a number of people were converting investments to cash, some managers of unlisted property froze redemptions from their funds.

Shares

Also known as equities (and stocks in the US). As a shareholder you are a part owner in a company; if you buy shares, you have bought part of a company. 

Generally, shares tend to:

  • Vary more in price than other asset classes;
  • Carry a higher risk of default, depending on the company. Running a business can be risky and as we have seen during 2008 and 2009, economic conditions can change rapidly. While many small companies come and go, even larger companies can collapse; and
  • Have varying levels of liquidity. How liquid a listed share is depends largely on its size and investor demand. Mining shares and the major bank equities are very liquid. Very small companies, such as some oil and mining juniors or biotechnology juniors, can be very illiquid and go for days or weeks with no trades at all.

Managed funds

A managed fund is a structure for investing in another investment. A managed fund pools money from different investors for the purpose of investing in one or more of the four main asset classes listed above, as well as other less known asset types. Through pooling funds, the managed fund benefits from economies of scale and increased liquidity.

 

To talk to someone about your investment portfolio, and if it is a suitable level of risk for your current situation and your financial goals;