FINANCIAL THEORY 101 AND RISK

here's an article from Marcus Padley. It's about risk. Maybe you kids ought to learn this NOW, not when you are old. read the last few lines anyway. It might put life into perspective!
Finacial risk 101
(101 usually means the first class in the subject at Uni.)
"Many people get lost when it comes to risk. What is risk? It's actually quite simple. But before you go off and plot everything with a return against how risky it is, i urge you to consider this.There is a natural assumption in almost every aspect of life, from playing a cricket shot to investing in the stock market, that there is a trade off between risk and return.

Nice concept but many people get lost when it comes to risk. What is risk? It's actually quite simple. In the financial world it is the difference between an investment whose returns fluctuate wildly and one that doesn't.

Risky business

Take two stocks. Both return an average of 5% a year. But one stock's annual return deviates from the average by 2% a year (so it can return 3% to 7% in any given year) and the other one deviates by as much as 10% a year (so it returns anywhere from minus 5% to plus 15%). Clearly the first one is pretty predictable and the second one is jumping around all over the place. It is much more risky. It is called standard deviation. But you can't tell that from the average return alone how risky something is. That's why, to judge the suitability of an investment, you need to calculate standard deviation as well. It is a measure of the volatility of returns or in common parlance, risk. It is a measure of how reliable your returns are.

Now back to risk and reward. If you can measure the average return (the reward) and compare that to the standard deviation (risk) and do that for every possible investment in the world and plot them on a chart of expected return compared to standard deviation (risk) then you start to get a picture of what you should and shouldn't be investing in.

Risk & reward

In a perfect world, a world that matched risk to returns without error there would be a straight line from the bottom left hand corner of the chart (low risk low return) to the top right hand corner (high risk high return). We have been trained by hitting cricket balls and by betting with bookies to expect this. Bookies after all derive the odds, or expected returns, straight from the level of risk. Bookies are a pure example of an efficient risk reward realtionship.

But before you go off and plot everything with a return against how risky it is let me just finish the lesson with one final addition to the chart. There is a base line all financial investments have to compare to. It's called the risk free rate. It's a simple thing. It's the return you can earn without any risk at all.

Traditionally in the investment markets this is represented by the return on Government Bonds. The 5 year bond yield is currently 5.3% and the 10 year 5.5%. So theoretically you can draw a straight line across your chart at a return of around 5.3% to 5.5% and any investment whose expected return is less than that that isn't risk free can be instantly discarded. Why invest in a risky investment that returns less than a riskless investment. Pointless.

Tax, fees & inflation

Where this gets interesting of course is when something plots above or below the lines. When the expected return does not match the risk. When an investment turns up as high return low risk, or low return high risk. They would stand out on the chart and be invested in immediately or discarded as stupidity.

So lets look at a few investments before tax, fees and inflation:

The stock market: Expected return of 9.38% (5.88% plus 3.5% from dividends). Risk 7 out of 10.
Bonds: Ten year return of 5.52%. Risk zero.
Borrowing money to invest in the market: Expected return of 9.38% less interest of 9.75% (tax deductible) = minus 0.37%. Risk 7 out of 10.
Paying off the mortgage: Pretax return of 7.81% (Standard variable rate) which grosses up to 10.6% pretax. Risk zero.
Marriage: Expected average return of one extra income, zero to four kids, two possible inheritances, a free life coach even if you don't need one, onerous school fees and a dog. Risk: Long term love, fulfillment and satisfaction.
Divorce: Expected return of minus 50%. Risks as yet unknown.

Now all you have to do now is work out how much risk you are prepared to take out of 10 and the investments you make in life will pick themselves.


Marcus Padley is a stockbroker with Patersons Securities and the author of the daily stockmarket newsletter Marcus Today. For a free trial of the newsletter, go to http://www.marcustoday.com.au/

Marcus Padley Stockmarket Secrets is a book for the current financial climate. With global markets crumbling, and many of the world’s leading markets entering into depression – the likes of which we’ve never experienced before – the time is ripe for a straight-shooting approach to money, wealth and investment.