I am going to attempt and point out the risks and returns in investing in various assets in general. Of course, while the list below is not complete and as comprehensive as I would like it to be, I will try to be fair and objective.
When doing a comparison, it is important for me to choose standards against which I measure each asset. And for this post, I am going to focus on three main types:
- capital loss
This is about how easy or difficult to convert an asset to cash. This is a characteristic that I think is crucial. Some of your decisions about financial planning might be focused around this.
For example, when you are about to retire and you would like that you have funds that you can readily drawn from for your daily living expenses.
It also becomes a factor in times of emergency situation or an urgent need, such as paying for school fees of your child.
This refers to the decrease of the value of an asset. It can be due to inflation; even when the total sum remains the same, its purchasing power weakens after the passing of years because of the increase of prices of goods and services.
It can also be attributed to unfavorable assessment (such as in the case of real estate), or the lower valuation (such as in the case of a managed fund or direct shares).
This denotes an estimate of an asset’s potential to earn.
Risk-Return Tradeoff: What is it?
According to the risk-return tradeoff, as risk increases, so does the potential return.
According to this theory, people link low levels of uncertainty to low potential returns and high levels of risk or uncertainty to large potential returns.
The risk-return tradeoff states that investing money can only result in bigger rewards if the investor is willing to tolerate a higher likelihood of losses.
What are the Risk Returns of Investing?
|Cash||High||None, but value decreases due to inflation||None|
|Bank accounts||High||None, but value decreases due to inflation||Low|
|Securities||Moderate to High||Depends||Depends|
1. Risks and returns of cash
Cash has the highest liquidity among all assets. In fact, everything else is converted back to bills and coins that you can use to purchase other things. You might think that this is good, but there is another side of the story.
When you put everything in the form of money, there are risks involved including:
- depreciation – The value of your cash decreases each year due to inflation.
- wear and tear – If you don’t put your money in the bank, chances are the paper in the bills and metal in the coins are going to be exposed to natural elements including moisture and heat, and they are subject to decay of the material or rusting.
- theft – Again, if it is not deposited in the bank, safekeeping becomes a concern as you would need to protect it from theft.
Perhaps its biggest drawback is the fact that it does not earn anything for you. It’s an opportunity cost that becomes ever more costly considering that there are ways to make it grow, and taking into account the effects of inflation.
2. Risks and returns of bank accounts
In accounting, this bank accounts should be called cash equivalents.
Bank accounts such as savings and checking accounts are next to cash in terms of liquidity. If your accounts are with a reputable and financially sound bank, then it is not hard for you to convert your account balance to actual cash either through an ATM or over-the-counter.
There is also minimal risk involved in safekeeping, as the bank is not tied to give back the actual money that you handed over during deposit. It can provide you newly minted paper bills straight from the central bank.
There is no actual capital loss, too. But there is a real decrease in terms of value over time. How? While your total sum is untouched, its purchasing power lessens because of inflation.
Say for example that you deposited P100,000 today, and you let it stay with the bank. After ten years, while your money is still an intact P100,000, plus any earned interest, its ability to let you buy goods and services will be eroded as the prices will be higher by then.
Lastly, banks offer very low returns. Right now, it was a mission looking for products that provide 0.50% annual interest rate in a savings account. Time deposits provide to only 1%.
3. Risks and returns of lifestyle assets
Your car, expensive phones, gadgets, and other things that are part of your life have moderate to very low liquidity. It is not easy to sell a worn-out pair of designer shoes or a run-down vehicle.
Capital loss is real, too. What it costs when you purchased it will never be matched when you try to sell it after your use. The longer something is in your possession, the lower its perceived value.
Finally, a lifestyle asset does not provide any returns whatsoever. Again, just like cash, it has very high opportunity cost. And that’s why it is always recommended to check what kind of asset you are accumulating over the years, as it may end up lessening your net worth.
4. Risks and returns of valuable belongings
Valuable belongings refer to pieces of jewelry, precious stones and metals, collection of works of arts, patents and other similar items. They are not easy to sell, and they’re also risky in terms of keeping them in the best condition at all times.
Capital loss and returns are something that I can’t estimate because it is a hit-or-miss. Either you have a treasure or a dud. A Picasso is without a doubt very valuable, but if it is in poor condition or discovered to be a forgery, that’s going to spell trouble.
5. Risks and returns of real estate
Real estate is perhaps a hot item. Over the past decades, this is a type of investment that’s familiar to many Pinoys, and may be the only asset that they know worth investing.
But what is the real story? It is not liquid. It is not easy to sell a property to get cash in return.
Do all properties increase in value? Well, it is hard to assess. It depends on many factors, including its location, how prone the area is to natural disasters, its distance to establishments such as government offices, banks, marketplace and utilities, among other considerations.
Capital loss or returns are therefore up to chance.
6. Risks and returns of a business
A business has low liquidity. It is hard to look for someone willing to buy a business, as its worth depends on many factors.
Studies have shown that 96% of new businesses fail in the first ten years. And that’s why I indicated really high chances of capital loss. But if it takes off and is managed very well, its returns can be surprising.
Securities are paper assets such as stocks, bonds and managed funds. Personally, they are relatively liquid because there is always someone out there (and sometimes even the company that issued the securities) willing to buy them regardless of prevailing market conditions, although not always at the price you are selling them for.
There are two kinds of capital loss in securities: not being able to get what you expect, and loss of the invested capital. However, it can be minimized through different strategies, including peso-cost averaging, diversification, re-balancing and longer time horizon.
Returns are therefore dependent on the type of asset, strategies being used and the length of total time for investment.
An investment idea known as the risk-return tradeoff suggests that the potential benefit increases with risk.
Investors must take into account a variety of aspects, including as their general risk tolerance, their ability to replenish lost cash, and more, to determine the right risk-return tradeoff.
When deciding which investments to make, investors weigh the risk-return trade-off for each investment and for the entire portfolio.