It feels a bit like déjà vu…
Developing plans and setting goals are part of the financial planning process. The other crucial element is how we invest to achieve our desired outcomes.
Investing may not be simply about growth, it can also be about providing an income or protecting money or perhaps a combination of all of these. Fundamentally it comes back to understanding our goals and through this we can look at the best way to invest (everything is interlinked).
Unfortunately, even understanding this doesn’t make it easy and investors are left to select the appropriate investment based on an outdated chart showing cash at the lower end of the risk spectrum and equities at the top.
There are many interpretations of risk but I am going to focus on the aspect of ‘investment risk’. The value of an investment going down one day and back up the next is not ‘risky’ in its true sense unless you have to sell when it has gone down! The challenge is to understand the level of risk and through this enable the most suitable selection of investments.
In this update I want to explore some key elements of each of the four main asset classes and how these can be blended to give the desired outcome.
Cash is seen by many as the safest asset class.
The event of 2008 were a wakeup call. It highlighted that chasing the highest return comes with risks. The collapse of Icelandic Banks meant many investors faced uncertainty as to whether they would receive their money back.
Fast forward to 2016 and with near-zero interest rates, investors holding cash face a predicament. Investing in savings products will perhaps provide interest of between 2% or 3% p.a. but only if investors are active in searching out the best rates. With little sign that much will change we are seeing new products come to market.
Attractive interest rates are being offered by the likes of Wellesley & Co, Zopa, Fund Setter and a rumoured new entrant Hargreaves Lansdown. These rates can be as high as 5% plus, and for obvious reasons this is being snapped up by interest starved cash investors.
It feels a bit like déjà vu…
High interest rates, what could possibly go wrong? Investors flock to these providers, some with little understanding of what they are signing up for.
These providers are not banks or building societies they are peer-to-peer lenders. Peer-to-peer lending (P2P) is a method of debt financing that enables individuals to borrow and lend money – without the use of an official financial institution. Peer-to-peer lending removes the middleman from the process, meaning that loan interest rates are often lower than those offered by financial institutions. For savers (who are the lenders) they benefit from higher interest payments. Simple! There are however two important elements to consider, firstly there is no guarantee the capital will be returned, and secondly these investments are not covered by the Financial Services Compensation Scheme.
The Icelandic Banks didn’t have the same compensation scheme which meant repayment for investors was tricky and only saved by the UK government. This didn’t have to happen. Defaults on peer-to-peer lending are very low but what happens when these are tested during a full recession; will defaults increase and how will this impact on investors?
In summary cash carries risk itself and like any investment it needs to be managed. It can protect on the downside and this can be important where it is needed in the short term.
Fixed Interest Bonds
These at a simple level represent a debt to a government, company or organisation. The person borrowing the money commits to paying a rate of interest up to the date of maturity. At that point the money is returned.
For example, a company issues £100 million in a bond (which is the loan) to investors with a repayment period of 10 years with 5% p.a. interest. Investors can take a share of the offer and during the term they receive the interest and then their capital at the end of ten years. There is no capital growth but you could argue that the interest is the growth.
On paper this appears to be a bit like a savings plan but locking the money away for a longer period of time. The risks are that the company defaults on the payment or return of capital and therefore part or all of the investment could be lost. If the company goes bankrupt, then any investor is a creditor so nothing is guaranteed and interest will stop.
Another risk is if the money is needed early, the bond can be sold in the open market but there is no guarantee at what price. Where demand is low the bond might be sold at a depressed price, on the flip side if there is high demand then it could be sold at a premium.
For this reason, many investors avoid holding bonds directly because of this risk and turn to a collective scheme (or investment fund) managed by a specialist manager. This reduces the risk but bonds are not the low risk investment many would indicate to be the case.
Similar to holding individual bonds when there is demand the value can go up making this an attractive investment, however when the market is depressed values can go down. This can be compounded where the manager is forced to sell more assets to provide cash to investors who want to leave, effectively creating a vicious circle because as prices fall more people want to get out and so the price goes down.
It is also worth adding that there are different types of bonds and investors picking the highest yielding bond don’t always understand the additional level of risk! (High yield bonds are issued by companies who have a greater potential to default, to compensate for this investors receive higher interest).
In summary, there is no doubt that bonds can provide lower risk investments but they do carry risk and investment values can go down (as well as up)!
Direct investment in commercial property is prohibitive for many investors meaning that the only way for many to get involved is via a fund.
These funds aim to give investors some capital growth with an income (rent from the properties held); as a sit and hold strategy on paper these seem a good investment.
2008 however highlighted a risk with these strategies. Many of these funds hold direct property (bricks and mortar), if investors want to take money out there is only so much liquid assets the fund can hold to pay these investors. When that is exhausted then the only option is to sell property. In 2008 we saw that investors had to wait many months before they could get their money and often with a considerable drop in value.
There are alternative ways to invest in property for example REITS are traded shares in property companies which take away the risk of getting money out. It is however worth adding that as shares they are susceptible to market movements and can be sold as much in good as depressed times!
In summary, as a buy and hold strategy property can be seen as a safer asset but there are no guarantees that asset values will not fall and just assuming it won’t happen doesn’t it mean it won’t!
Investing in shares is seen as very risky.
However, within that investors who hold direct shares believe they can control the degree of risk. Holding “safe” blue chip companies guarantees a degree of share growth plus dividends. For high octane growth, new share issues offer fantastic opportunities for growth which we don’t see with “safe” companies.
The reality is that buying the shares of any companies directly carries significant risk whether it is a household name or not. Of course the share values can go up, but equally they can collapse and also stop paying dividends. This makes holding shares very tricky and most investors will turn to funds to provide that exposure.
Similar to bond or property funds research has to be done although the options are much wider; which country or countries do you invest in, what size companies etc etc. The risk is greater than other asset classes but in theory the returns should be greater. Investors can access money at any time but the timing of this will determine whether this is at a profit or loss.
In summary, shares do carry more risk but the level of risk is dependent on how you access them and where you invest. On the flipside returns should be higher than other asset classes.
This time next year
The reality is that whether you invest in cash, bonds, property or shares each of these come with risk. Just holding one asset class can increase risk, rather than decrease risk.
It all comes back to the plan and desired outcomes. To achieve them will need different approaches to how we invest. A short term plan may need cash, whereas a longer term plan may need a mix of some or all of the different asset classes.
Trying to guess the next big thing to achieve goals early is likely doomed to failure. Achieving our goals is not an overnight fix, it is a slow methodical process which assuming is well managed should deliver the required outcomes.
Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.