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Choosing the Right Investment for You …the difference between ‘good’ and ‘bad’, ‘low risk’ and ‘high risk’ investments

20 February, 2012

The GFC (Global Financial Crisis) of 2008, and on-going global volatility, has left many cashed-up investors “shell-shocked” and wondering what is a relatively safe investment that provides a reasonable return? The realisation that fixed term interest deposit rates are not likely to increase for some time, together with the devaluing effect of inflation, means that many are now actively seeking to move their funds into higher-returning long-term investments.

While I strongly support property as an investment class, primarily because of the inherent security, control and transparency that it offers, I also acknowledge the importance of having an open mind. As any investment advisor will tell you, one of the key rules with investment is to diversify i.e. spread risk.  For those who favour property, it is possible to diversify within the property asset class through a whole range of different property types and, of course, other asset classes are also options worth considering.

Regardless of the asset class, one of the golden rules of investing is to consider the risk profile of the investment options.

What is ‘Risk’? There are many definitions of risk, but I would define investment risk as being the difference between the ‘expected returns’ and the ‘actual returns’ over a given time period.

Let’s assume that we have $100,000 and compare 2 investment options – 1) fixed deposit in the bank and 2) investment property.

The Bank – on today’s rates you would receive 4.75% for a 2 year deposit. This is virtually zero risk because it is almost guaranteed that you will receive 4.75% return on your money.

Property – you could invest your $100,000 and buy say $250,000 worth of property (60% gearing). Prior to 2008 residential property had increased in value, on average, approximately 10% per year over the long-term. However, many might argue that in the short-term the market could sit static for a few years – or even drop in some areas. On that conservative basis, let’s assume that we can invest in a property with growth prospects of 5% p.a. – half the historical average. No-one has a crystal ball, and there are no guarantees with property. As such it could be suggested that property is ‘high risk’ because the actual return may vary quite significantly from the expected return, especially in the short-term.

If we had the $100,000 earmarked for a tax liability in 2 years time, would we be better to put it with the bank or invest it in property? The answer is pretty obvious. The bank is a good, short-term, low-risk investment and the $100,000 will be available when you need it. If it was invested in property, who can say what the value of the property will be in 2 years, and how easy it will be to release those funds?

However, if we had the $100,000 set aside as our retirement fund, or to build an off-farm investment nest-egg, with a time-frame of 10-25 years, then it would be a different story. The $100,000 fixed-deposit with the bank would, at current rates (5.85% for long-term), have increased in value, with compound interest, to around $176,566 in 10 years. However, with the benefit of time and riding thru the ‘up and down’ cycles, even at a conservative 5% growth rate, the $100,000 in $250,000 property should have increased to over $257,223 (after deducting the original $150,000 mortgage)! ! This example assumes that the property is cash neutral – the rental covers all outgoings.

It doesn’t take a rocket scientist to work out which is the better long-term investment. In this scenario, property is a good, long-term, high-risk (because returns vary over time) investment and an investor would be unwise to even consider the bank as an option. The fixed deposit would have been, in this situation, a bad, low-risk investment.

Conclusions:

*        It is possible to have good and bad low risk investments, and good and bad high-risk investments.

*        Always consider the time horizon for your investment plans.

*        While there are no guarantees that historical returns will always continue, apply your own common-sense and informed judgement to take a position that you are comfortable with. For example, knowing that property has, over the long-term, averaged 10.2% return, a conservative investor might well base their numbers on only 5% annual average for the next 10 years.

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