Saturday, October 31, 2009

What are you risking?

Someone sent me a newsletter that essentially is an advertisement to buy some diversified funds. Attached in the newsletter is this picture which I found it very interesting. This is, of course, not the first time nor the last time I’ll ever see this picture. I’ll like to take some time to think about the myths portrayed in the diagram.




The diagram shows the investment risk pyramid, where the highest and presumably highest returns are placed right at the tip of the pyramid. At the base, and therefore forms the foundation of the whole pyramid structure, lie the no risk and presumably lower returns (in fact, negative returns). You can see that cash is defined as a no risk instrument.

I think everyone should define what they mean by risk. In the academia world, risk is volatility – or how much the price of the instrument varies from its mean price. In that aspect, then the investment risk pyramid would make perfect sense.

However, I find that definition of risk a bit inadequate for my laymen, non-academic purpose and $-minded purpose. Risk, at least for me, is defined by how much you can lose for how much you want to gain, i.e. I risk $10 to bet that this team will win, so that I can get back $15. My risk for earning $15 is $10. It does not really matter to me if the it yo-yo up and down since I know how much I can lose and how much I can win. I suppose in that sense, the pyramid does not make sense to me at all.

I know the risk of holding cash - it will be lower each year after accounting for inflation (which is around 3-5% pa). It's invisible but the effects can truly be felt. In the past, I can go to the food court with $3 and have a full meal. Now, I can barely fill my stomach or even buy anything with $3. So, I'm questioning if it's right to treat cash as 'no risk'. In fact, the risk of holding cash is that you will lose some 3-5% of it every year.

Going by the same argument, if you treat shares as the second highest risk group according to the investment risk pyramid, it doesn't make sense to me too. Yes, shares are highly volatile (actually, have you seen those illiquid stocks that pay high dividends before? Vicom, anyone?) hence it has one of the highest volatility. This means that it's 'risky' since the price fluctuates wildly about its mean. Well, they can go ahead and classify them as risky but I'll do it anyway. Not dabbling in shares intelligently is the most risky thing you'll want to happen to your financial health.

After reading through the newletter, the punchline came. It offers a product that gives a guaranteed annual return of between 2.30% to 2.55%. Sounds good isn't it? Better than fixed deposit - a fact that they never fail to mention.

Thanks but no thanks.

12 comments :

Musicwhiz said...

Hi LP,

The bigger question is what they invest in to get such returns? Obviously, they have to earn from the spread; so it's like saying they probably can get 5% or more over 5 years and are just paying you the 2.55% and keeping the rest.

If one buys a good company for yield, I am sure it can be better than 2.55% assuming you choose the right company and at the right price.

Cheers,
Musicwhiz

la papillion said...

Hi mw,

Ya, I think about that too. And when I think how they can invest my money and give me only a part of their profits while they keep the rest, I think about what they invest.

I think I can't be do much worse than them, haha

Createwealth8888 said...

It is hard not to think of price volality as risks. Train harder and not to think it as risks

Createwealth8888 said...

Don't get confuse over different type of risks. Inflation risk is a different class of risk. What about Sing dollar risk, etc?

The Investment Risk Pyramid is comparing the different levels of risk of losing your capital.

la papillion said...

Hi bro8888,

Thanks for your insightful comments. I mean I know that there are different types of risk but never really thought about it in this context.

Thanks for pointing that out :)

Lau said...

Hi LP,

I agree with cw888 that the diagram is of the risk of losing one's capital.

BUT, it is very subjective. Eg, unit trust can be riskier than shares as majority perform poorer and incur high management fees. And derivatives can be least risky depending on how you use them.

Anyway, from a marketing perspective, how does that diagram help to sell that structured product?

la papillion said...

Hi Lau,

I guess that the newsletter is selling a savings product. Being savings product, they are touted as having very low risk yet earn higher yield than fixed deposit, hence the need of that diagram.

I'm trying to highlight to pple to question the things they read. Nice charts and fancy diagrams, if it didn't pass through the common sense test, might be dangerous to one's financial health.

I esp have something against market truism. Things should be made as simple as possible, but not simpler. Oops, I just said one truism...

PanzerGrenadier said...

Hi LP

Risk is relative. The sellers of investment/savings products never tell you the biggest risk of all:

that of IGNORANCE about your own finances!

:-)

Be well and prosper.

Mike Dirnt said...

Yo LP,

long time no see. glad you are still around. :P

i kind of disagree with you about Vicom. There is actually no proper definition of risk for stocks. But the common measurement to calculate risks are standard deviation and beta of the stock. Actually a less risky stock is one that is illiquid.

From a layman point of view, an illiquid stock is less subjectible to price manipulation. So its standard deviation is lesser.

I did not do a standard deviation calculation for Vicom. but if you pluck out its beta from DBS Vickers, the number is just 0.536 :P

la papillion said...

Yo Mike,

Haha, long time no see :)

I knew you'll disagree with me on Vicom :) What I don't like about risk is its definition as volatility. I don't think volality measures risk for me...but as bro8888 mentioned, there are many different kind of risk, even though there's only one word for it.

Risk for me is just defined as how much you can lose for how much rewards you want to get. If I managed to get such a low price that the chances of it gng lower is so small (esp after the cost is lowered by dividends), my risk is actually lowered - nevermind the volatility of it ")

Musicwhiz said...

Volatility definitely does not equate with risk.

Risk means the possibility of losing a substantial portion of one's original invested capital.

Cheers,
Musicwhiz

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