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Do the risks justify the rewards?

RISK-return trade-off is a phrase widely used in the investment industry. But what does it mean in practice? How does the average investor decide if their portfolio is generating suitable returns to justify the risk?

There are a number of ways of looking at investment risk. One is the risk of an investment failure. This generally applies to speculative ventures but can include large and respected businesses. The recent failure of HIH Insurance is a prime example.

Perpetual Private Clients’ Steve Davis said the risk of failure can be minimised by focusing on quality investments, characterised by strong earnings growth, good and stable management, cash reserves and conservative debt levels. Another strategy for minimising this risk is to diversify, by holding a broad range of investments. If one investment fails, it will have only a minor impact on the total portfolio.

Hartley Poynton’s Graeme Yukich applies a handy rule to ensure appropriate diversification. He says that each investment should be no less than 2 per cent of the total portfolio and no more than 10 per cent.

Once an investor recognises the need to diversify, they have to decide how their money should be allocated across the main asset classes – cash, shares, property and fixed interest. That decision will be influenced by many factors, including the investor’s current situation, their lifestyle and financial goals and their tolerance for risk.

In this respect, there are two useful ways of looking at investment risk – the year-to-year fluctuation in returns and the possibility of negative returns.

Of the main asset classes, cash has the smallest fluctuations. Annual returns have ranged from 5 per cent to 18 per cent over the past 15 years. At the other end of the scale are international shares, which have produced annual returns ranging from minus-10 per cent to 56 per cent. Similarly, Australian shares have experienced very wide fluctuations in their annual returns.

A second way to assess risk is the likelihood of negative returns. This is highest for investors in Australian shares. As shown in the table below, Australian shares are likely to experience negative returns in two out of every seven years. The reward for incurring this risk is a comparatively high return (based on continued low inflation of 2.5 per cent per year) of 8.5 per cent per year.

Property investors also face a high risk of negative returns. However, Mr Davis said that when property returns are negative, it is by a comparatively small amount compared with shares which can experience large annual falls. Consequently, property should not be considered as risky as shares, and therefore the expected returns from property are not as high

Cash sits at the other end of the risk-return spectrum. Cash investments never experience negative returns and this is reflected in the lower returns of about 5.2 per cent per year.

Mr Davis says Perpetual’s projected returns are deliberately conservative. Nevertheless they are consistent with research by Paterson Ord Minnett, which found that long-term real returns (ie the returns above the inflation rate) have averaged 5-9 per cent per year for shares compared with 2-6 per cent per year for fixed interest and cash.

This risk profile explains why prudent investors should look at Australian and international shares as a long-term proposition (ie at least seven years). This period of time gives the shares sufficient time to recover should their value fall in the first few years.

Another strategy for minimising the risk of fluctuating and negative returns is to diversify across the major asset classes. When one asset class is in a period of low or negative returns, other asset classes can prop up the total return.

In this respect, investors need to look at each investment in the context of their overall portfolio.

“It must be remembered that in portfolio construction we want to reduce the overall risk profile of the portfolio, not the individual assets within the portfolio,” Mr Davis said.

“A ‘risky’ asset, when combined with other assets, may actually reduce the risk of a portfolio, leading to a more desirable risk-return trade-off.”

Asset class Likelihood of negative annual return

Likely return Cash Nil 5.2% Australian bonds 2 years in 10 6.0% Listed property trusts 2 years in 7 8.0% Diversified portfolio 2 years in 9 8.1% International shares 2 years in 8 8.5% Australian shares 2 years in 7 8.5%

Source: Perpetual Private Clients

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