Risk is not in itself bad – Part 2

By BILL BLEVINS [email protected]

Bill Blevins is Managing Director of Blevins Franks. He has specialised in expatriate investment and tax planning for over 35 years. He has written books and gives lectures on this subject in Southern Europe and the UK.

In my last article, I covered institutional risk and fraud risk to your investments. This week, I move on to explore investment risk, which is often misunderstood.

Many people think investment risk is just how risky or volatile particular assets are, but that’s not the whole story. It’s the probability of an asset or assets achieving your investment objective.

First, you should identify what your investment objective and income needs are. For example, retirees probably want to ensure their money lasts for the rest of their lives, maintaining a decent standard of living. Their objective is to beat inflation and maintain buying power throughout retirement.

Next, you need to determine the choice of investments to achieve your objective. Many people choose cash in the bank, seeing it as low risk because the capital doesn’t fluctuate and a positive rate of interest is added each year.

In reality, although cash is low risk, it’s also medium risk and high risk in terms of achieving investment objectives.

Looking at this by way of two extreme examples:

John is buying a house in six months. The property will cost €300,000, which he has in the bank. His investment objective is not to lose any money in the interim. For John, it would be nonsense to consider anything other than cash holdings because over the time frame other options would bring a positive or negative risk to his capital and he may fail to hit his objective. For John, cash is a low risk solution.

Diane has recently retired and her life expectancy is 20-30 years. She has capital from which she’ll need to take income. Diane considers keeping the money in the bank and drawing the interest each year. However, the interest Diane receives will be reduced by tax, her income will rise or fall as interest rates change and each year her capital will lose value as inflation wears away at it. If Diane’s objective is to maintain her buying power over the remainder of her life, then holding her assets in cash is a very high risk strategy.

Taking another extreme, let’s look at equities from a risk perspective. In the short term, equities can increase or decrease in value and are more volatile than cash. Given John’s objective, it would be misguided to consider equity investment. However, in the longer term, equities produce above inflation returns so for Diane they would be considered lower risk than holding cash.

Another dynamic is that the risk of holding any asset class continually changes.

For example, the risk of holding cash increases if interest rates fall relative to inflation, or if tax rates rise. Given how low interest rates currently are, there’s a clear argument that cash now carries a higher risk for anyone other than short term investors.

Looking at equities, bond funds and property (known as ‘real assets’), there is a further dynamic to consider. The higher their values get, the greater the chance that they will fall – as we’ve witnessed in relation to the UK housing market. However, if their value falls, they become less risky.

In reality, we find ourselves in quite a bizarre situation. The economic crisis and stockmarket falls have resulted in equity investments becoming less risky given the current levels of the markets. While they could fall further they are less risky than they were.

Are equities cheap?

We don’t have a crystal ball but there are a number of things to be aware of. Markets start to move forward well before the economic situation begins to improve and often these price movements are quite significant. Investors who wait until economy improves will often miss out on much of the rise.

Another factor is Price Earnings (P/E) ratios. A company’s P/E ratio is calculated using its stockmarket value and dividing it by its annual profits after tax. If a company has a stockmarket value of say £100 million and annual profits of £4 million, then its P/E ratio is 25 – i.e. 4 x 25 = 100.

If a company’s stockmarket value grows and its annual profits don’t, the P/E ratio will increase. If its value falls and profits are maintained, the P/E ratio will fall. Analysts use P/E ratios as a way of identifying whether company shares appear expensive (high P/E ratio) or good value (low P/E ratio).

Research from Russell Investments into the US stockmarket (S&P 500) shows that P/E ratios are currently lower than the historical average dating back to the 1940s.

They are also currently at or about the same levels when compared to the end of average bear (falling) market over the same period. Russell states that “the same analysis shows that the general cheapness seen in the US extends to other markets”.

Of course, P/Es are based on past profits. If they were to fall significantly, today’s P/E ratios may not with hindsight appear to be cheap.

Equities and cash are not the only solutions. Bonds have a very important role, and are offering yields unheard of in the past. There are high yield bond funds providing an income of over 15 per cent net of all costs as of early December 2008.

If you wish to protect the buying power of your wealth then, based upon your investment objectives, timeframe and attitude to risk, you could consider investing in a balanced and diversified portfolio including equities, bonds, property and cash. It’s important to take professional and authorised advice from a company such as Blevins Franks.

To keep in touch with the latest developments in the offshore world, check out the latest news on our website www.blevinsfranksinternational.com