Taking a risk or risking getting taken

By Mark Fryer

Before you start debating whether to invest in shares or property, overseas or in New Zealand, or who is the best unit trust manager, ask a simple question: what do you want? And, equally important, what risks are you willing to run to get it?

While investment can be complex, many of the answers come back to those two simple questions.

Taking some time to get them right will help when it comes to working out the best portfolio - the mix of investments that has the highest chance of producing the results you want, while keeping the risks at a level you can live with.

The portfolio that suits a young investor who is thinking of retirement 30 or 40 years away, for example, will be very different from what is needed for someone who has already stopped work and is relying on their investments to cover day-to-day living expenses.

To see how it works in practice, we asked Girol Karacaoglu, general manager of WestpacTrust Financial Services, to come up with three model portfolios to fit three very diverse circumstances.

Others may have different ideas of the appropriate portfolios, but the results (see table) make the point: what suits one investor may be far from suitable for another.

One of the most important things, says Mr Karacaoglu, is to remember the difference between "saving" and "investing."

Saving is putting money aside for some specific short-term purpose, whether it is a holiday or a deposit on a house.

Typically, what savers want is to preserve their capital, which means they should choose investments at the lower-risk end of the scale.

Investment, on the other hand, is about creating wealth, usually for some long-term goal such as retirement. Here, the focus is on increasing capital rather than just preserving it, which may require taking some more risks in the hope that over time they will lead to higher returns.

Mr Karacaoglu says investors should also remember that their total return comes from two sources.

One is income - cash paid out on a regular basis, such as interest payments or dividends on shares.

The other is capital growth - the increase in the value of an investment, such as a rise in a share price or in the value of units in a unit trust.

One of the big differences among the three portfolios is in the relative percentages devoted to growth and income investments.

At one extreme, the young, aggressive investor has 72.5 per cent of his or her investments in the form of shares, but only 27.5 per cent in investments that aim to produce income. At the other end of the scale, the couple approaching retirement have 80 per cent of their portfolio in income-producing investments, and only 20 per cent chasing growth.

However, income investments are not just for savers - even long-term investors may want to have some of their money in investments that produce income.

One reason is liquidity, or the ability to get at some of your investment quickly, without having to pay a penalty or suffer a loss because you have to get out of an investment when the market is down. It is not just what you want that affects the makeup of your portfolio. Your tolerance for risk in all its forms (see below) should also play a part.

The tradeoff is that while growth investments are likely to be volatile - share prices may soar one year, then plunge the next - in the long term they are likely to produce higher returns than income investments.

For example, looking at the assumptions that form the basis for the model portfolios, international shares are forecast to produce a return of 9.9 per cent after tax, while "cash" (money in short-term deposits) is expected to earn a much lower, but much steadier, 4.02 per cent.

While the attractions of the higher-risk, higher-return strategy may make sense if you are in for the long term, investors who are older or just more cautious may feel the volatility is more than they can bear. They may be willing to settle for less, knowing that at least their earnings are likely to be relatively steady.

At one extreme, says Mr Karacaoglu, an investor who is very shy of risk and only interested in earning income may choose to stick with term deposits, even in the knowledge that their overall return is likely to be much lower than they might get if they invested some of their money in shares.

He says it is also important to remember the difference between gross returns and the net results - what is left after tax, fees and inflation have taken their toll.

The attractions of the "indexing" or "passive" approach to investing in shares becomes particularly apparent when you focus on the net returns, which is a result of the tax advantage that strategy enjoys.

While all this talk of portfolios and risk tolerance may sound somewhat removed from the quest for the best return, it does matter - and it makes much more sense than hunting for the best investment without first deciding on your over-all strategy. Knowing what your goals are, and putting together a portfolio that fits those goals, is a good way of avoiding a panic attack when markets fall.

If it takes a plunge in the market to reveal that you are actually highly averse to taking any risks, you could find yourself being panicked into selling your growth investments and moving into something less volatile at the worst possible time.

But if you have your eyes wide open to the risks in the first place, know how long you are investing for and have a strategy worked out, you are much less likely to make a bad decision in the heat of the moment. Talking over factors such as investment goals and readiness to take risk is also important for couples.

If two people have vastly different attitudes to risk, there is a good chance of coming up with an investment strategy that pleases no one. While one partner lies awake at night worrying, the other frets over missed opportunities. In such cases, both sides may have to compromise, or split their investments and go their own way, financially at least.

It is also important to think through these issues if you are seeking professional investment advice. There is no point in an adviser coming up with a strategy that promises super-high returns if you are not prepared to take the risks that go with it.