Risk Mitigation when Saving or Investing
September 28th, 2009 Investments, Observations, Retirement PlanningThis will address;
- The types of risk you face with your money
- Balancing the risk you need to take -v- the risk you are willing to take
- The value of guarantees
The first premise is to understand and accept it is not possible to avoid risk with ones money. Ironically, our experience strongly
indicates those individuals who are most risk averse, inadvertently take some of the highest risks in their quest to avoid risk.
The vast majority of individuals and trusts have their money in one or more of the following asset classes,
Cash, Gilts and Bonds, Equities and Property. Each of these is subject to one or more of the following risks;
Capital Risk (reducing in value in absolute terms)
Interest Rate Risk (if an investment provides a fixed return and interest rates increase generally, its return becomes less attractive)
Inflationary Risk (if net returns are less than inflation, the capital is decreasing in value in real terms)
Liquidity Risk (a lack of readily accessible capital could lead to a forced sale of an asset or investment in adverse market conditions)
Exchange Rate Risk (A gain on investments made abroad, subject to a foreign currency, could be eliminated through unfavourable changes in the exchange rate)
Stock Selection Risk (The risk of failing to accurately and consistently select what to buy and what to sell)
Market Timing Risk (The risk of failing to accurately and consistently buy and sell assets at the right time)
In addition to the above, are further risks associated with either the individual or a specific holding;
For many there is a real risk of severely depleting capital due to the impact of one or more of the following, operating expenses, taxation and the income demands placed on the capital.
Here are two typical examples;
An individual who professes to be risk averse, places £300,000 on deposit split equally between two banks. After tax, he is getting a net interest rate of 3%. Inflation is running at 2.5% and he requires £12,000 p/y (inflation proofed), to supplement his other income. After deducting inflation he is getting a net ‘real’ return of 0.5% yet he needs an income of 4%. Thus he has depleted his capital by 3.5% this year compound. If he continues to draw this level of income he is likely to exhaust the capital in circa 17 yrs.
In addition, should one of those institutions fail, only the first £50,000 is ‘protected’ under the Financial Services Compensation Scheme, (FSCS). There is a double risk here;
Firstly the loss of £100,000 not covered by the FSCS. Secondly, the guarantee on the remaining £50,000 provided by the scheme is NOT a ‘guarantee’ but a ‘promise’. The institutions pay a levy to the scheme which would meet modest pressures upon it. Should there be a serious demand in excess of the reserves, this is supposedly guaranteed by the Government of the day. Yet if the public purse is empty; the Government would be required to go to the money markets to borrow the money to meet its commitment, if the markets think the Government will default on the loan they may either not lend or apply punitive interest rates. In short the Government is backing up the FSCS with a ‘promise’ to meet excess demands upon it, subject to it either having the means or being able to borrow the monies.
Thus this individual is subject to Inflationary risk, Taxation risk, Capital Risk (as he is depleting it through his demand for a level of income it cannot support) and further capital risk in the event of the failure of one of the institutions.
Example two;
It is now quite common place for us to deal with individuals who own an investment property portfolio, be it residential or commercial. So here we have an individual who owns 6 Buy to Let properties valued at £1,200,000. There is a gross income yield of 5% (£60,000). These are geared at 60%, thus total borrowings of £720,000 on interest only mortgages, at an average interest rate of 4.5%. He thus has £60,000 in income from which he pays out £32,400 in mortgage interest payments. At face value this shows an attractive surplus of £27,600 for the year.
However, if we dig deeper we find the balance shifts. We need to assume there are rental voids, (which there almost invariably are), conservatively at 10%. Thus Gross rent is now £54,000. From this we need to deduct, ground rents, maintenance charges, property maintenance costs, Landlord certificates, letting agent fees, utilities, insurances, accountancy fees, typically 15 to 20%. We will be generous and assume 15%. Thus net rents are now £45,900. After the interest charges, this leaves net rent of £13,500. Deduct tax at 40% and this reduces to £8,100 net income return. That equates to 0.0675% return on the assets, (ignoring potential for growth in value over the long term). An alternative way to look at it, is the return on the individuals ‘own’ money tied up in it, (the amount in excess of the borrowings), in this case, £480,000. Then it would be a net return of 1.68%.
If inflation was averaging 2.5% he is losing money in real terms and is reliant upon the first elements of capital growth in the properties to rectify the shortfall in return against inflation. Only then is he going to make money unless he can rely upon progressive real increases in rents going forward.
In this case the risks faced are even greater, interest rate risk, (increasing rates in the future), taxation, capital risk (falling property prices and net returns below inflation), stock selection, (which properties to buy and sell), market timing, (when to buy and sell them), liquidity, (have excessive amounts of capital tied up in illiquid assets could cause him problems elsewhere in his life), possible exchange rate risk, (if some of the properties were abroad), operating expenses, (there could be significant increases in labour and material costs in the future).
In summary, the means of securing the lowest levels of risk is to diversify across the various asset classes and to take only the degree of risk with you capital necessary to meet your lifetime objectives. If the risk you need to take is greater than you are comfortable with to secure your required return, then you have to find an acceptable balance between discomfort and moderating the demands you make on the capital, thus reducing the returns you require of it. Additionally, prudent tax planning, can also reduce the strain on the returns you require of your capital.
