Understanding the risk return equation

Share

Take a deep breath… we are about to enter the secret world of financial risk and return measurement…

.

How long is long term? How do you balance risk and return?

These would be two of the shortest questions to ask yourself, yet they are also two of the hardest questions to answer. It does not matter if you are an individual planning for your retirement or an executive in charge of a $200 billion investment fund – the principals remain the same.

Super funds are a good example of this, as it is a requirement of funds that they balance their investments with their expected cashflows. That is, they need to work out when they would expect to receive money (through income on existing investments, contributions to member accounts and insurance premiums) and when they are likely to need to pay money out (in rollovers or retirements or death payments). A fund is expected to allocate their investments in such a way that the money is available for these payments, while still earning enough to meet the retirement needs of members.

In the ideal world, if you are able to meet all of your payment expectations from investments that are held entirely in cash accounts then you would have no need to take any investment risk to achieve your objectives.

 From a financial planning perspective, it would be a pointless exercise, and so you should leave your money in cash. Of course, there are people who would be able to live quite comortably on this basis and yet they still invest into shares and property and areas that have the capacity to fall in value, as much as they have the potential to rise.

If you are able to meet your needs through cash then logic would dictate that it is only your personal preferences that would cause you to move out of a full cash holding.

However, few people or institutions are actually in a position where cash will provide all that they need and want. In Australia, the RBA cash rate is 4.5%. On that basis, obtaining a regular income at the level of the Age Pension (~$28,000 pa for a couple) would require lump sum of $622,222’ish. Not everyone has that much money available for producing an income. A financial planner will look at the net return, which means we must account for inflation and tax. For the moment, let’s assume a benign tax environment in which you don’t need to pay any… (just close your eyes and savour that thought). If we are to deal with inflation then the RBA tells us the current inflation rate is 3.1%pa as measured by the consumer price index (CPI).

If inflation continues at this level then you will need $37,996 in 10 years time to have the equivalent purchasing power of $28,000 today. If you still have your money in cash, and haven’t dipped into it for car upgrades, new kitchens, holidays or living costs then you will still have $622,222 in your account. To earn $37,996 you need the interest rates to be at 6.1%. Maybe they will be and maybe they won’t. Interest rates tend to follow the inflation rate. Therefore, for rates to be at 6.1% it is likely that inflation over that 10 years would have exceeded the current level, meaning even $37,996 won’t be enough and you are still behind – unless you are able to live on 36% less income – which is highly unlikely.

.

In other words, you need to earn a higher rate of return if you are going to cover the effect of inflation on your living costs over the average retirement lifetime.

.

Most people want to consider a life of earning enough income for an active lifestyle into their 80’s. For most this is going to mean a 20 year investment timeframe, at the least. In the example above, the need to dip into the bank account to make up the shortfall in living costs will erode the bank balance until after around 26 years there is nothing left. For some people this is ok. They are prepared to accept that with careful control of expenditure, they will at least be able to meet their living costs into their 80’s (if you retired somewhere between 55 and 60). In Australia, there would most likely be some form of Age Pension entitlement that would kick in eventually, as the level of investment assets decreases below whatever are the relevant thresholds at the time. However, most people want a chance to do better than this.

So let’s say the individual with $622,222 now wants to find a higher rate of return. How about moving just a little further up the risk slope and searching out term deposits? One year term deposits are currently paying 6.5% for amounts over $250,000. This means our person with $622,222 can now earn $40,444 a year. If they keep their spending to the equivalent of $28,000 today then they are able to increase their bank account by $12,444 in the first year. This extra 2% is helpful but our investor is still 1.1% shy of the inflation rate, which means they will eventually need to eat into capital to meet their ongoing income needs. Let’s assume the differential continues for the entire 10 years we looked at previously. The term deposit person is better off than the cash person but still does not have enough to live on without dipping into their capital or reducing their lifestyle – and we are starting from the Age Pension level, so there is not a lot of room to reduce costs. However, this person (assuming all other variables stay the same) has enough income to meet living costs the equivalent of $28,000 today for around 38 years before the money is completely gone. If you retire at 55 that takes you to 93, so that has to be a reasonable outcome.

The negative to this is that term deposits are currently offering one of the highest premiums over cash seen for a long time. This is because of the banks’ competition for deposits to reduce reliance on offshore borrowings. Whether this continues or not is open to debate.

Let’s get back to the risk/return profile business. IF you can earn 6.5% instead of 4.5% then to obtain your $28,000 in todays money and account for 3.1%pa inflation then you only need capital of about $500,000 for your money to last for 26 years. In other words, you can have the same lifestyle as the person earning 4.5% but with $122,222 less capital.

This is a good example of how a few extra percent can make a big difference to your long term objectives.

.

To recap – a person who accepts a higher level of risk has, in this case, a better chance of achieving their preferred outcomes.

Warnings to be considered include :

  • Potential “break costs” if you find you need to access term deposit money early
  • Rapidly increasing interest rates reducing the comparative value of your term deposits verus simle cash
  • The security of the underlying institutions. This is one of the most difficult areas for any person to deal with – and it doesn’t matter if you have a degree in Finance, Engineering, Medicine or Fine Art… you simply are not going to be able to make “sensible” decisions on relative risk between major institutions (such as Australia’s “Big Four” banks) as the scope of issues that are implied by the term “risk” simply fail to work when looking at institutions in this way. Feel free to argue this one with me. Before doing so, please prepare a comprehensive summary of the relative strengths and weaknesses of Commonwealth Bank versus ANZ Bank, specifically as they relate to the security of my banking deposit. Rest assured that i will read any such essay with particular glee.

We will look at the risk and return relationship quite a bit over the coming months. Feel free to comment or criticise.

 


Related articles:

http://www.michaelsmusings.com.au/financial-planning/how-do-financial-advisors-assess-and-apply-risk-strategies/

Warning and Disclaimer : This article is NOT providing you with financial advice and you must not take any investment steps based on this article, as it is of a general naure only and cannot be considered personal financial advice. For further clarification of the differences between “general advice” and “personal advice”, please read the article here :

http://www.michaelsmusings.com.au/warnings-and-disclaimers/

Share

Leave a Reply