Why Low Risk Can Be Good

My issue relates to the risk taken and the way assets are allocated by the 'average' investor. By asset allocation, I mean the asset class into which money is invested (for example - unit trusts, currencies or shares) rather than the actual asset (for example - investing in Shell or BP rather than Barclays or HSBC if you were buying shares).

This, for me, is an issue because I keep meeting people that seem to have no idea of the risks they are taking or have taken with their money and the likely effect to their wealth. As a general rule, people treat the investment world in the following way:

Bank account = boring / safe

Shares = exciting / slightly risky

Property = interesting / safe

Currencies = exciting / complicated

Hard assets = boring / dull

Unit trusts = complicated / dull

Bonds = mirth

Why is this? What is it about investments that makes people switch off their minds and take risks with their money that they just do not understand?

As a guide, people should generally invest with a safety first approach to the majority of their assets and take understandable risks with a small and manageable portion of their wealth.

To help us understand the issue a little more, let us look at the problem with some logic.

What is risk?

Risk in relation to assets describes the level of volatility in the price. The ultimate risk is that (for whatever reason) your investment plunges to a value of nil and never recovers. Perhaps the business folds, shares are suspended and bankruptcy arrives. For me, I was rather fortunate to learn this lesson very early on and rather cheaply. I bought shares in Wembley plc (owners of the football stadium) - my very first shares - when I was 18.

The shares were a 'turnaround' that never turned. When I bought, the shares were so low in price that I didn't think they could fall much further. (I think they were about 1.8p each.) How wrong was I? As I recall, I managed to turn roughly £250 into about £12.50. Ho-hum. Interesting, disappointing and as I say, a cheap learning experience in the long run.

Price volatility more usually means that the value of an asset might swing quite sharply and potentially spend years trading at a price less than paid. This means that things will be 'bad' for a long time. It doesn't necessarily mean that the investment was based on bad advice or reasoning, or that the manager is bad - sometimes life is just like that!

I mention this stuff because of the weird and wonderful investments people seem determined to make. For example, why invest in a hedge fund? I know several people that have in the past invested substantial sums into hedge funds. These people are not poor, but they are not exactly wealthy. Only a few years ago, hedge funds were the preserve of the super rich and minimum investments started at around $100,000. Of course, US$100,000 isn't what it was 15 years ago!

The risks associated with hedge funds (sticking with my example) are pretty high on the scale. Many hedge funds make massive profits, but charges are enormous (most have performance related fees of around 25% of all profits on top of normal 'fund' fees), money invested is locked in for several years at a time and they are generally regulated very, very lightly.

Yet, the people invested in them (that I have met) consider themselves to be 'low risk' investors. Is this because they have done all their high risk investing already? Or is it just this one investment that is out of line with their aims?

I fear that the answer is neither. I believe the answer is ignorance. Now that may not be their fault. I have one client who owns some hedge fund assets and did not realise that was the case until I pointed it out. In her defence, she was very surprised by this news. She had asked for a safe investment that would 'plod'. Well, she got the plodding part!

Perhaps I am trying to over think this. Perhaps it is just GREED that makes them throw away their normal values. Who can say?

Another example would be the people (and we all know one) that trades in shares, or futures, options or whatever and is relatively successful. It is great that they have the skills and financial backing to play the markets in this way. But even these 'sophisticated' investors usually have money in the bank, their home and a collection of futures contracts and nothing else. Again, this is a highly risky proposition. Should it go wrong and they stop earning, they have lost a second income (or perhaps even primary income) and a majority of their savings. This means that even the people you may think of as being financially 'savvy' are usually rather skewed about their goals. And if it isn't shares, it is property...

Instead, these people, in fact pretty much all people, need to get a good selection of basic investments behind them. Very few people that I meet ever invest in either corporate or government bonds. These bonds are loans to major corporations or governments on which interest is repaid and at a preset date, the capital is also repaid. Bonds are an actual asset class of their own, in the same way that shares or cash are.

I suggest this as an idea. I am not trying to say that bonds are a great investment now or that they will be the best investment from here for the next ten years. I am just trying to present an example of another type of investment that seems to go largely unused by the people I meet. When I prepare fund portfolios for clients I often get a laugh of derision when they see a bond fund. They are right to use the words, 'That won't make me rich!' but only partly so because bonds don't tend to make people poor.

Try to remember that if you want to invest but cannot stomach the idea of losing money, then shares probably are not for you and 'exotic' investments even less so.

In the experience of some of my clients that have been holding wierd and wonderful assets for years, the word 'exciting' when referred to investments now actually means 'expensive mistake'. Finding a low risk home for money may be boring, but if the money is still there when you need it five years from now, it wasn't so bad - was it?

Of course, there is another side to all of this. One of those being commission. If you are, lets say, a hedge fund manager and your fund charges enormous fees, you might be able to pay salesmen quite a tidy sum to sell your product. Alas, cash truly is king and for many a salesman this is what counts (rather than the actual investment). Happily, I can look back and admit my mistakes. I have never sold a hedge fund - I would probably be wealthier if I had!!

Sticking with hedge funds, there are a few that have made huge sums. George Soros is THE example, but there are several others. Speculators with Nostradamus like gifts. However, I read recently that there are now over 7,000 hedge funds worldwide. The problem is that they are all attempting to do the same thing. This makes it very difficult for even the greats to make the same amounts as they once did. (Yes, they all still charge the same though...)

In conclusion, I would like you to take away a few things from this. Firstly, that in investment, boring can be good. Secondly, that these high risk investments can become expensive mistakes if you do not know what you are doing (even though you may think that you won't 'need' the money for a few years, does not mean that you plan to lose it all). And lastly, when discussing investments with any adviser, ask him or her to check that you have enough bonds. If not for yourself, then do it for me.