Understanding Financial Risk - Part 3

Financial Risk

While it may seem intuitive to spread your investments around, there is some science behind the process. We can diversify in a number of ways.  Read below to learn more.


This blog is the final article in a three-part series explaining Financial Risk.  In this article, we will discuss the importance and relevance of diversification and other investments that may affect your financial situation. If you have any questions, or wish to discuss financial risk further, contact one of our friendly Independent Financial Planners today.


Diversification

Diversification means combining assets which have prices that move in different directions. For example, buying shares in an oil producer (e.g. Woodside) and a company dependent on fuel (e.g. Qantas) will allow you to reduce volatility due to external factors (the oil price in this case) while retaining the combined return of the two shares. Diversification allows you to increase the return and/or lower the risk when two or more investments are combined in a portfolio.

While it may seem intuitive to spread your investments around, there is some science behind the process. We can diversify in a number of ways:

  • Spreading your share portfolio across a range of industries or sectors. Bank shares, retail shares, mining and resources equities and biotechnology shares would all behave very differently in a range of different economic circumstances;
  • Diversifying across asset classes. Shares, property, fixed interest and cash all benefit at different stages of the economic cycle. Ideally, falls in one asset class are offset somewhat by gains in another; and
  • Diversifying across international borders. Certain events (such as local economic conditions or internal politics) may affect one country, but not another.

OTHER INVESTMENTS

While we have discussed the basic asset classes, there are other less common investment options. These investments are often extremely complex, and therefore unpredictable. Also, they are typically very expensive, reducing investor returns.

Managed Investment Schemes

Managed Investment Schemes (MISs) are similar to managed funds where investor funds are pooled for an investment. Typically, the underlying investments in a MIS are more out of the ordinary, such as plantation timber, almonds and olives. MISs can be aggressively marketed, with many making use of the upfront tax deduction granted by the Australian Taxation Office (ATO) as a marketing tool.

Despite the attraction of an upfront tax-deduction, the liquidity issues, lack of transparency and questionable investment potential of the underlying assets make MISs a relatively high-risk investment.

Structured Products

A Structured Product is one that uses a range of financial engineering techniques to produce a particular proposed outcome. An example could be a product that borrows internally, invests in a number of shares, but holds options against these shares to protect against a downturn. Capital protection may seem attractive, but ultimately the investor pays for it through higher borrowing costs.

We tend to find that as the layers of complexity build up, so do the management fees associated with the product.


SUMMARY

  • Investment risk refers to the chance of financial loss;
  • The higher the return you seek, the higher the investment risk required;
  • The major asset classes from least to most risky are: cash, fixed interest, property and shares; and
  • Through appropriate diversification, risk can be reduced for a given required return.