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.

It's September and there is some confidence showing

After nearly 18months of bad share trading, ( a BEAR market) confidence seems to be returning and the market is rising again. (the BEAR is turning into a BULL and we hope there is a stampede by the herd which will push prices up.)This confidence is because America seems to be improving and although their unemployment rate is still high, people are buying houses again. (but can they afford the sure- to- rise interest rates?) Right now there are still many cheap shares under ten cents.

I recovered all the losses last month, and we made over 5000.00 profit on the shares I recommended. they were ABY.AX (bought at 11 cents and sold at 1.oo)
and MCW.AX bought at 17 cents and sold at 63 cents.
many of the under ten cents shares are rising slowly. so the message is:
if you invest $500.00 and a 1 cent share doubles, then you double your money and make another $500.00 plus get your investment back.
But of course you have to buy the right shares.. so what "sector" is likely to rise? energy, mining, food , banks, etc?? and what can we afford to buy with 500.00? That is the question.

Ask yourself, what has sold well before and dropped in the recession.? what was the previous high and low for the year (or check for two years). what has risen recently? so who knows what? why are people buying this particular stock?
go to the www.asx.com.au , check in the market statistics for volume each day. (after 4.30pm) see what rose and write down the companies that were cheap. then go to company research and look at their graph. Then go to www.yahoo.com. and type into the finance section the code plus .ax, example aby.ax and see the information quoted. you could also goto google to see how much money the company has.. it really needs to have a few million in the bank. say 50 mill. that is called capitalisation. too low and they might go broke, and you will lose all your money..
to learn more you can visit the pages at www.asx.com.au for heaps of free learning.
Making money on the share market is a JOB. you earn your money because you do research.
you do take risks, but you spread your risk by not putting all your eggs in one basket.

best of luck .Mega

Rich kids feel poor

I thought with the last year (2008) sharemarket crash, that the grandkids would be sworn off their shares.. I mentioned casually, "well, I would've given you all more shares for your birthday or Christmas, but I guessed that you wouldnt be interested."

Three teenagers put up their hands. "Yes please we're interested".
Lloyd asked.. "but weren't they all worthless?"
His mother interjected, "yes, they fell but we havent sold and now they are rising.. the sharemarket is in recovery."

So capitalism is still alive and well, and hope still sparkes!

That's good, because it means they realise that you have to continue to look to the future, and what happened yesterday, does not always predict what might happen tomorrow.