Last time round we looked at the two main things you can do with your money as an investor.
You can lend your money out: known as ‘buying debt’, or you can own an asset, technically known as owning equity.
With these in mind, now let’s look at risk.
Of course there are many different risks in the world which could affect your investments. A company whose shares you own could start to see falling profits. A regulator may impose limits on what a particular business sector can do. The economy may go into a slump, with a knock-on effect on shares and property, for example. And in a mass panic in the markets, even very solid companies can see their share prices walloped.
But let’s start at the most basic level of all: the risk of losing all your money.
With a ‘low risk’ investment, the chances are that you’ll get all your money back, whatever happens in the markets. With a high risk investment, you could well lose most or all of it. Obviously this is something you need to think about!
Here’s a brief rundown of the risks involved in the main asset classes, starting with the least risky and moving on to the most risky.
Cash: you’ll get your money back
As long as you keep your money in a savings account to below the level of the government’s deposit insurance scheme (£85,000), then cash is as close to 100% secure as you can get. You shouldn’t suffer a ‘nominal’ loss at all. In other words, if you put £100 in a savings account, you’ll always get your £100 back (plus any interest you might have earned).
Even if your bank goes bust, the government’s insurance scheme covers you up to £85,000.
The main problem with cash is that it’s unlikely to beat inflation over the long run. In other words, its value may fall in ‘real’ terms. If the interest on your savings account is 3%, but inflation is running at 4%, then your money is actually losing 1% in value every year.
But the nice thing about cash is that as long as you are sitting on some, you can take advantage of any investment bargains you spot.
Government bonds: low-risk, but a small chance of losing money
Bonds are IOUs. If you buy a bond, you are lending money to the bond ‘issuer’, for an agreed length of time. Governments and companies issue bonds to raise money.
If you buy a bond, in return you receive a fixed amount each year (the ‘coupon’). Plus, at the end of the loan period (the ‘redemption date’), you also get back the bond’s face value – usually the price it was issued at.
That’s the benefit of bonds: a nice, dependable, fixed stream of income, and getting back the face value of the bond at the end of the loan period.
The biggest risk for a bondholder is the danger that the issuer won’t repay their debt.
UK government bonds, known as ‘gilts’, are seen as very safe. For centuries, Britain has always repaid its debts. And the UK government could always increase taxes, or print money, to repay its bonds if it got into trouble. In other words, with the credibility of the UK at stake, it’s extremely unlikely that any holder of gilts wouldn’t be paid their regular coupons, and the value of their gilts on the redemption date.
Of course not all government bonds are seen as safe. Countries with dodgy economies (e.g. Greece) can fail to repay their debts. In the polite jargon that financiers use, this is called ‘defaulting’. In this situation lenders may only get back, say, half their money, or even less.
However, there is another way you can lose money on bonds. During their lifetime bonds are traded in the market, and their prices go up and down. A bond with a face (‘par’) value of £100 might actually trade for, say, £95, or £105.
So if you bought a bond above its face value and held it to the end of the loan period, you would lose money – because at redemption you only get back its face value. For example, you buy a £100 bond for £105, and hold it to redemption – at which point you’ll only get £100 back. (Although you will have received all the coupon payments in the meantime).
Corporate bonds: riskier than government bonds
Investing in corporate bonds – or investing in government debt from more exotic nations – is riskier. Depending on how creditworthy the borrower is, you have to consider the chance that the borrower will go bust before they can pay you back. The riskier the borrower, the bigger return you’ll want for your money.
That’s why the yield on Italian government bonds is higher than that on gilts, for example. And it’s why a big company like Tesco, issuing ‘investment-grade’ bonds, will be able to borrow at a far lower rate than a smaller, riskier firm, whose bonds might be classed as ‘junk’.
Corporate bonds are less risky than the equivalent shares in a company. That’s because if a company goes bust, bondholders stand in front of shareholders in the queue for whatever can be salvaged.
Equities: you have a share in the growth, but can lose a lot too
When you buy an equity (or a ‘share’), you are literally buying part of a company. It might not be big enough to give you much say in the running of the company, but it does make you an owner. This means you are entitled to a share in the profits of the company.
So unlike a bondholder, who gets a fixed return, a shareholder in a growing company should share the benefits of that growth. On the other hand, if the company gets into trouble, the shareholder is fully exposed, whereas the bondholder has an element of protection.
In short, the risks involved in being a shareholder are bigger than those of being a bondholder. And that’s why the potential returns are bigger too.
Property: don’t forget that it’s usually financed by debt!
Property is a slightly odd asset class. Unlike a company, the value of a property is very unlikely to go to zero. It’s not impossible, clearly, but usually you’d expect even the worst property to have some value. So technically speaking, it should be less risky than shares.
However, most property is bought with debt. You put down a 10% deposit, say, and borrow the rest. Imagine you put down a £10,000 deposit to buy a £100,000 home, with the other £90,000 borrowed from the bank.
When you buy something with debt, you immediately increase your risks. Say the value of the property falls by 20%. Your £100,000 home is now only worth £80,000. You’re worse off by £20,000.
Not only have you lost 100% of your capital (the £10,000 deposit), you’ve lost another £10,000 on top of that, and you still owe the bank £90,000.
If you now sold the property you’d only get £80,000 for it. You’d be left owing £10,000 to the bank. In other words, you’ve lost more than your initial stake. This is why owning an investment property – when it’s financed by debt – is actually quite a significant risk for most people.
As for commercial property, the only practical way for small investors to get diversified exposure to this sector is through a professional fund that buys commercial property, or through a stock-exchange-listed real estate investment trust (REIT). That’s why I prefer to view property as a sub-section of ‘equities’, rather than as a separate asset class for your portfolio.
Speculative assets: not really investments at all
Wine and art (known by investors as ‘collectibles’), commodities and currencies all fall into the realm of speculative assets: you are primarily making a bet on the price rising or falling.
I am not saying there’s no place for these in your portfolio. But when you invest in them, you need to have a very good grasp of why you think you know better than the market. And you should have an exit strategy firmly in place.
Gold falls into this category. Here at MoneyWeek we think there are very very good reasons to hold some gold in your portfolio. We’ll deal with those in a separate email.
What you should do now
What assets do you already own? Which of these categories do they fall into? Do a quick review of your assets, and think about the risks involved with them.
And are there any we haven’t mentioned here that you are unsure of how to categorise? Let me know in the comments below.