Making Sense of Investment Choices, Risks and Rewards

A Sense for Money

Savers face a bewildering array of choices when deciding where to invest. Bank deposits, bonds, equities, real estate and mutual funds are examples of the many vehicles available. Each investment type has its own individual characteristics, risks and rewards.

This week, we are sharing with you some basic information of what they are and how they work. Hopefully, this will provide you with some insight to help you select which investment types are best suited to your personal circumstances.

Bank deposits are the simplest form of investment. You place your cash in a bank account, and the bank periodically adds interest to your account. You may choose an immediate access account where you can withdraw your cash and accrued interest at any time. Alternatively, you can choose a term deposit where the bank guarantees to pay back your capital plus a fixed rate of interest at the end of the term. The capital risk associated with bank deposits is minimal. Your only risk is that the bank becomes insolvent and is unable to pay back your funds. The flip side of the low risk is that the investment return from bank deposits is normally also relatively low and there is no upside potential in terms of capital appreciation.

A bond is where an organization, which could be a company or a government, borrows funds from investors and agrees to pay interest at, for instance, 10 percent per annum and to repay the capital after, say, 20 years. Investors can buy the bond either at outset from the issuer or at a later date when original investors sell. The interest rate payable, known as the coupon, is usually fixed throughout the lifetime of the bond and, in general, the longer the term of the bond, the higher the coupon. Borrowers who are less financially strong, or who do not have a solid track record of profits, need to pay a higher coupon. Thus, a government bond may yield 8 percent while a bond issued by a second tier company may yield 12 percent or more. This is an example of the risk-reward trade off: you can get 4 percent higher reward from the second tier company but the risk is that it goes bust and you could lose not only the coupon but also your entire capital. The risk-reward trade off is something encountered frequently in the investment field. The normal scenario is that the higher the return offered, the higher the associated risk.

Another characteristic of bonds is that you can make capital gains (or losses). Imagine that you are one of the initial investors in the investment mentioned above — a twenty year bond paying 10 percent per annum. If interest rates fall dramatically, say to 5 percent per annum, then you are on to a real winner, as you are locked into 10 percent for the duration while new bonds will only give 5 percent. As a consequence the market value of your investment will rise by almost 100 percent. This characteristic of bonds — that their value increases as interest rates fall — is something that novice investors sometimes find surprising. Conversely, rising interest rates lead to a decrease in the value of bonds.

An equity is a share in a company. For example, a company may be founded with a million shares of one dollar each. This gives the managers of the company a million dollars working capital which can be used to build and grow the company. A small investor may buy 1,000 shares when the company is set up, and in return receives shareholder rights, such as the right to vote at shareholder meetings, the right to dividends in the company and the right to sell the shares in the future. If after one year’s trading the company declares a dividend of 5 cents a share, and the price of the shares has risen to $ 1.80 then the shareholder will have achieved a dividend yield of 5 percent and a total yield of 85 percent. Conversely, if the company had totally failed and lost all the US$ 1m, then the shareholder would have lost his entire US$ 1,000. The good news is that the individual shareholder’s maximum loss is limited to the US$ 1,000 invested. This illustrates the nature of equity investment: choose the right stocks and you can get rich quickly. Choose the wrong stocks and you can lose your shirt.

Many small investors prefer to get exposure to the various asset types through collective investment schemes such as mutual funds or insurance funds rather than by direct investment. Collective investment schemes enable small investors to pool their funds, obtain a diversified spread of investments and access professional management. Specialist and sector funds are available that enable you to choose the sector while the professional managers pick the individual investments within the sector. Bond funds, commodity funds, overseas equity funds and real estate funds are examples of sectors that might tempt some of you. Naturally, fund managers make a charge for their services but the hope is that their expertise will generate an additional return that will more than cover their fees.
 
For more handy financial tips, follow A Sense for Money on Twitter @senseformoney.