Why risk and return are linked
Investment A is the obvious choice…
A
… but add
A
risk, is the
choice still
obvious? B
B
B would die out through lack of takers!
▪ Inflation risk is a major problem with the more “conservative” asset classes such as fixed interest and cash. Many pensioners find to their horror that they can no longer live off their savings, despite the conservatism of their strategy, simply because inflation devalued their money and the portfolio did grow enough to keep up.
▪ Averaged out over many companies, shares as an asset class tend to respond to interest rates and the economy.
▪ Although in the last few years many markets have fallen substantially, shares are still the highest performing asset class over the long term.
When two investments appear to offer identical risk, investors will prefer to buy the higher returning one. If the market is peopled by reasonably well informed investors, there simply won’t be any high returning low risk investments left and nobody will buy high risk assets with a low expected return.
▪ In a portfolio construction context “risk” is usually measured with some sort of measure of price volatility.
▪ There are other risks of course that need to be taken into account.
▪ Portfolios can be constructed that exhibit superior risk and return relationships to any single asset, because one can significantly reduce risk by diversification.
▪ It is necessary for all but the most short term oriented investors to consider at least some exposure to growth assets like shares and property, just to fight inflation.
▪ Shares generally go up in price over the long term because businesses don’t pay out 100% of their profits as dividends, they keep some to grow the value of the business itself.
Major asset classes: shares
▪ Shares are part interests in businesses. How good a return you get on your share depends to a large extent on the fundamental business developments of the company itself and on the price you paid for the share.
▪ Over the long term, shares have beaten inflation.
Major asset classes: property
▪ There are many types of property to invest in, each are different.
▪ The highest income yield comes generally from commercial and industrial property.
Chapter Oy
Part One
The asset classes
Basic principles
▪ There are many asset classes and many of them are useful to investors.
▪ Some asset classes are noted for their long term stability (low risk), others for their high returns.
▪ Generally speaking, the higher the reward you are after, the more risk you’ll need to take.