The Impact of Risk

In our previous newsletter, we looked at the impact of the capital growth and the yield of an investment asset by considering an example of an investor owning shares in a fictitious company.  The example looked at the different outcome that would result, depending on whether the investor was seeking an investment which offers the prospect of a high rate of capital growth or an investment offering potential for a high yield.

The example was based on a choice of an investment in two different companies and compared the outcome that would result depending on how much of the return generated by the company was taken as yield and how much contributed to growth.  The example was based on the assumption that each company would deliver the same constant annual rate of return on assets, where the total return received from an investment asset will be the combination of its growth in value over time and the yield it delivers along the way.

But what if one of the companies was able to deliver a higher return than the other?  Wouldn’t it therefore be a better investment?

Investors will typically base investment decisions on how they expect that an investment asset (such as a shareholding in a public company) will perform in the future.  Their view on the expected future performance may be determined based on information from a variety of sources, such as an investment adviser, the media, personal research into the company in question, etc.

One of the factors that should be taken into account in this decision is the level of risk involved in the investment under consideration.  In common usage, the word risk is generally used to describe something bad which might or might not happen.  There are two key areas of risk that an investor will generally be concerned about – the risk that an investment asset will not generate the expected level of yield or income, and the risk that it will not deliver the expected capital growth.

To take the example of our fictitious company, they may have a bad year, not making the level of profit that they (and their investors) had expected, and so they may end up paying a smaller amount as dividend, so that the investor has a lower yield.  In an extreme case there may be no profit to distribute, and so no dividend and no yield.

However, things can get worse.

Many companies operate with high levels of fixed costs – costs which have to be paid regardless of how well the company is selling its products, such as building and equipment leases, interest costs, etc.  If the company is not generating enough income from sales of its products to cover these costs, it will end up making a loss, so that instead of the value of the company increasing year on year, it will actually fall, resulting in a capital loss for the investor.  In an extreme case, the company’s losses may be so much that they cannot continue in business, in which case the investor is likely to lose all of the money that they had invested.

Given that our investor could take their money and get a virtually guaranteed level of return, for example by placing the money in a term deposit with a bank, we need to understand why they would choose instead to expose themselves to these risks.

In most cases, the answer will be “to get a higher level of return”.  It is a generally accepted principle in the world of investment that higher levels of return are associated with higher levels of risk.  If a company wants to attract capital from investors, and there is a risk that the investor may lose some or all of their expected growth or yield, then they need to offer a higher level of return that the investor could get without taking this risk.

Different investors will be comfortable with different levels of risk, and may use sophisticated strategies to build a portfolio of assets with differing levels of risk, depending on their investment objectives.

In the case of someone trying to develop a portfolio of investment assets to provide them with a passive income stream in retirement, it will be vitally important to minimise, mitigate and manage the risks associated with the selected investments to ensure a high level of confidence that the desired outcome will be achieved.

So in developing an investment strategy and selecting investment assets, getting the correct balance between risk and return is going to have a major impact on the outcome achieved.  This is a critical factor in the success of a long term wealth creation strategy, and one of the reasons why Empower Wealth considers the choice of investment asset to be such an important decision in implementing an investment strategy.

Empower Wealth’s Personal Wealth Management Program includes a sophisticated Wealth Projection Simulator which allows you to see the effect of asset selection decisions by modelling the effect of different returns, together with all the other factors which influence the long term financial outcome of an investment, to give you the numbers you need to make an informed decision about your financial future.

If you would be interested in seeing how these tools and techniques could be applied to your own personal financial situation, please come and see us for a free one hour consultation by registering at our website or just give us a call.