The Relationship Between Risk and Return 2

When choosing where to invest your money, do you give much thought to the risk involved, or just the return (reward)?

Many people made the mistake of chasing the higher returns of finance companies just prior to the Global Financial Crisis (GFC).

The interest rate (or return) of the investment should reflect the risk of the investment.

There are two risks that you face as an investor.

  1. The risk associated with the return “on” your investment (ROI, or income generated by the capital invested)
  2. The risk associated with the return “of” your investment (getting your capital back at the end of the investment term)

Prior to the GFC, most people were giving more thought to the return on their investment (the interest rate they would be paid), rather than the return of their original capital invested.

I expect that the tide has turned now and people are more cautious of being able to get their money back at the end of the term, rather than chasing a higher return at the risk of losing their funds.

I was prompted to write on this topic today in hearing of a young property investor who has recently bought an investment on Auckland’s North Shore.  The young man is happy with a capitalisation rate (many investors call this a yield) of just 5.7%.

There is a lot of speculation in the Auckland (and Christchurch) property market around how long values will continue to increase over the foreseeable future.

Nobody has a crystal ball, but what we do know is that the Reserve Bank is actively trying to cool the market down.

With the already high prices being paid for Auckland property, and the likelihood of rising home loan interest rates, I’d be wanting a better return on investment than 5.7%.

It’s true that there “might” be some capital gain to be made from owning this property in the future, but that is taking a rather large punt and borrowing a lot of money (I’m assuming the borrowing is at around 5% interest) to gamble on future increases.  With the other expenses of holding the property, I expect that this “investment” is not generating any income for the young investor.

With easy access to credit, many people are jumping on the band wagon in the hope of huge capital gains in the near future.  A number of these hard-core investors are hoping to “recycle” their deposits within 3 months of any purchase.  That’s great if it happens, but I don’t believe that anyone should be relying on being able to do this.  I just hope that they are doing their budgets based on a more conservative home loan interest rate of 7%, or even 8%.

As it turns out, the house that my husband and I currently live in was destined to become a rental in the future when we upgrade to somewhere a bit bigger and better. We are now considering selling this property when the time comes, because the rental return would be around… 5.7%!

A gross return (before interest, rates, insurance, maintenance, etc.) of 5.7% is just not enough to take the risk of renting out a property in the methamphetamine capital of New Zealand – West Auckland. Whilst we believe that our property management ability is robust enough to avoid encountering a P laboratory, the risk associated with this is too great to be satisfied with such a small return.

Investments should be made with heads screwed on correctly and brain engaged.

There is nothing wrong with investing in higher risk assets, but you need to be well educated in whatever you choose to invest in.  Don’t jump in just because someone else has had success.  You might have the timing wrong, or they may simply have a lot more knowledge than you.

So, what are the lowest and highest risk investments and their likely returns?

(All of these returns are per annum, pre-tax)

As a base figure, we can use the Risk-Free Rate of Return (RF Rate) which in New Zealand was 2.41% as at 30 June 2013.  The RF rate is based on the return on Government bonds. This return is not going to get you anywhere quickly, but it is considered risk-free because you are very unlikely to lose your money.

At present a serious bonus type savings account offers a better interest rate (around 4.00%) than a term deposit of less than a year (around 3.85%).  You’d be silly to take the term deposit, which costs you the opportunity to touch your money for the chosen term.  With a savings account you can have a slightly better return on investment and still have the option of withdrawing your funds if you really need to.

As you’ll know from the time value of money post, you want a higher return if you are locking your money away for longer.  This is why longer term deposits pay more than shorter term ones.

Buying property has advantages because you can use OPM (Other People’s Money) to invest and you can often improve the property (decorating etc.) and select your own tenant.  New Zealanders love property because it is tangible – they can touch it and drive past it.  Everybody needs a roof over their head, so property is seen as an easy and safe investment.  This is not always the case.  Property investment requires quite a bit of education for you to reduce the risk involved with your investing.

You need to understand the cash flow (rent less all expenses); know how to choose the right property, in the right area; and know how to find and manage good tenants.

Property investing is not nearly as lucrative (in cash generated), or passive (management and maintenance) as you’d like to think.  There are definitely good capital gains to be had, but don’t expect to retire off the rental income in the short term.  Property is a long-term investment, and does come with risks such as bad tenants, natural disasters, and Government tinkering.  You need a decent return to allow for the risks and effort involved.  A well-known investor accepts 1.5% over the home loan floating rate as a minimum gross return.  At present you’d need a 7.25% return to meet this criteria.  There are not many Auckland properties that are in low-risk areas that will provide that return at present.  If investing in less desirable areas, then you need to add at least another 1% to that to allow for the extra risk.

A higher risk option could be a property syndicate, such as this one which is offering a projected return of 8.5%.  Property syndicates are good and bad.  They are a good idea because $100,000 on its own isn’t going to buy you much, but if you pool it with others then you can buy a share of a good quality commercial building.  They are bad because you don’t have the control that you would have if you owned the property outright.  They can also be hard to liquidate if no-one else wants to buy your share in the building.

Shares – over the long-term (say 20 years) shares average a return of 10% – 12%.  The only problem with shares is that there is huge volatility risk.  If you are in no hurry to get your money out, then shares could be an option, but if you find that you need to access funds and shares have dropped 20%, that’s going to hurt!

Whatever you decide to invest in, make sure that you educate yourself as much as you can.  Always remember the correlation between risk and return.  If the return sounds too good to be true, it probably is!  

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2 thoughts on “The Relationship Between Risk and Return

  • David

    Hey Meg. Good stuff as always. Couple of thoughts. Re: shares – Index Funds may help reduce the volatility and risk. Re: Commercial property trusts, one option for making your share more liquid may be to form a company to purchase the share in the commercial property. Then if you need a bit of cash in the future, you can sell off some of the shares in your company. Doing it this way may also make it more affordable as the cost could be split over the initial shareholders in your company.