Business

With risk comes reward

SSL in the Money

Ryan Strachan

Wednesday, October 24, 2012    

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WHILST I do not consider investing to be an exact science akin to that of studying rockets, I would not dare classify it as being as simple as picking three stocks out of a hat and hoping for the best either. There are many factors at work which include perception, market sentiments, human emotion, familiarity (which explains that even while it was expensive and the underwriters were greedy, Facebook was bought by many first-time Jamaican investors because they know and use the product), and risk tolerance. The points mentioned may feature in future 'In the Money' instalments, but the subject of my next three contributions will pertain to risk. Having defined risk, the end result will be to establish equilibrium between risk and rewards and allow readers/active investors to proceed accordingly.

In the context of investing, 'risk' is a concept that I'm sure many persons hear about but may not comprehensively grasp or understand in a working sense. It is my belief that one's degree of familiarity with this notion can be the difference between selecting an otherwise classified 'risky' investment option and making significant gains and standing on the sidelines complaining about low yields/interest rates and the lack of 'money in the system'.

The Oxford Dictionary defines risk as "a situation involving exposure to danger" and when applied to investing, the danger is the likelihood of losing a portion or one's entire investment principal. This also explains the usage of the word 'exposure' by many noted finance personalities. With that said, it figures that with risk comes reward and the two are directly correlated as instruments with higher risks bear the potential for greater rewards.

This will lead to the conclusion that instruments and schemes promising guaranteed (which suggests low risk) rates of high return buck this trend and could be reasonably termed as unrealistic and likely doomed to collapse. Such an unfolding may sound familiar to some of my readers who were in the loop in the years 2008 - 2010. It may also cause those who expressed similar views in 2008 to be deemed clairvoyant, but, I digress.

The key question is: how does a complete understanding of risk allow one to benefit in times of fiscal uncertainty? Let us start by outlining some asset classes and the practical risks involved. Beginning with real estate, the owning of multiple properties and collecting rental income may benefit the investor (owner) who is seeking hard currency ('cash') returns and would prefer to own a physical asset. Conversely, with these benefits come potential risks which include — liquidity issues stemming from tenants not paying on time, maintenance, landlord risk associated with ownership of a property, and many others. This may shed a different light on real estate for the liquidity risk has left several overseas real estate magnates — who I'll decline to name — in money issues in the past and would definitely cause one to think twice ahead of overloading an investment portfolio in this asset class.

Another popular investment option is fixed income which carries predictability of returns and relative safety. The inherent drawbacks include the risk of a default (loss of principal) and interest rate risk where in the case of longer-tenured holdings, one could be exposed to potential opportunity cost from increases in 'base' interest rates, and a potential benefit results of course were interest rates to fall whilst the investor is holding the instrument. This explains why in the past bonds and preference shares have been 'called'; by virtue of changing market conditions and falling interest rates, borrowers have recalled instruments in issue and paid-back lenders in order to access cheaper funds in the market.

The risk associated with equity investments/owning a business (they are the same thing!) are most pronounced, for they include the possibility of the business failing, and similarly, a decline in stock price. The benefits are also extreme for if this business is successful, it can include above-average returns, voting rights and stable dividends which can supplement personal cash flow. For the purpose of this discourse, I find it important to state that risk is dynamic; the risk involved with equity is seldom equal across the board for the risk of a start-up company and that of an established business differ greatly. This should also determine the price one is prepared to pay for either. The more extreme risk-averse investors should be cognisant that saving money under one's bed also bears the risk of moths destroying and thieves stealing as per Matthew 6:19.

To conclude, let me share the belief that investors should be aware of all risk involved in any particular investment undertaking. This is where the rubber meets the road and where the need for learned advice is critical. The reality of the matter is that regardless of where one chooses to place their hard-earned capital, risk exists. Subsequent parts of this correspondence will seek to further elaborate on the compensation for and the components of risk. The key to risk management however, begins with understanding and comfort with the risk assumed; and then being fairly compensated, which is of far greater importance.

Ryan Strachan is the manager of the Wealth Division at Stocks & Securities Limited and can be contacted via rstrachan@sslinvest.com

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