Why risk and return go hand in glove

By MARY HOLM

Q. I am considering investing with a finance company, but I keep getting told that the higher the interest rate, the higher the risk.

Everyone I ask says, "Yes, that's true", but no one can really tell me why that is true.

It is a bit like believing that the sun comes up in the east - which is not true, if you think about it.

It seems to me that the success or failure of any business is entirely dependent on the quality of the people running the business.

I keep reading about many apparently substantial companies losing their investors' money, so what to do?

I would appreciate your comments on why the term "the higher the interest rate, the higher the risk" seems to be perceived as always being true.

A. First, let's look at your statement about business success depending on the quality of the people.

It's true that every move a company makes is made by people. But some highly intelligent and honourable people have made what turned out to be terrible business decisions. There's got to be an element of luck in there.

On to your main point. To understand why risk and return are closely related, put yourself in the shoes of the finance company you are lending your money to. (Okay, grammar teachers, I know it should be "to whom you are lending money". But who talks like that any more?)

We'll call the company Iffy Co. The people who run Iffy are just like anybody else. They want to pay as little interest as they can on the funds they are raising.

If they're offering you 10 per cent, then that must be because they've found they can't borrow enough if they offer 9 per cent.

Why not? Because would-be investors have researched their company and the projects they invest in and decided it's all too risky.

They would rather lend to Safer Co at 9 per cent. They won't be enticed into Iffy unless they get a higher interest rate to compensate for the extra risk.

Having said all this, several commentators have recently said some New Zealand finance companies don't pay enough interest, given their riskiness.

That suggests that too many people are willing to invest in them without a full appreciation of how risky they are. And, admittedly, it's not easy for the ordinary investor to judge that.

You can get some guidance from www.bondwatch.co.nz, but that service uses only publicly available information.

It doesn't probe into a finance company's unpublished details.

Unless you feel equipped to do that, or get advice from someone who does, you're probably best to stick with lower-interest investments - perhaps investment grade bonds. A stockbroker can tell you more.

If you must chase after higher interest, at least spread your money over several finance companies. They probably won't all default.

As for the sunrise, it looked pretty easterly this morning. But perhaps you prefer the outer space perspective.

Q. A recent letter referred to the Hong Kong rich list and how property developers were well-represented.

The letter implied that property developers and investors are the same, when in fact there is a huge difference between them.

Developers buy vacant land or old buildings, improve them and hope to sell all or parts of the completed project at a profit.

Their finance costs are high because the process is fraught with risks.

These risks include approvals, construction costs and the future market for their product.

Investors buy existing property (or sometimes developers' products off the plan for a low deposit). They can borrow quite easily because a valuer can value it and a banker can see it and evaluate how it stacks up.

Some developers get very rich and quite a few go bankrupt.

Some property investors get quite rich and very few, if they are prudent, go bankrupt.

A. Good point. And you're not the only one to make it.

Duncan Balmer, author of The Investment Jungle and Stop! Do Not Invest in Residential Property, wrote along similar lines.

"When considering the Frank Lowys or Mr Lis of this world, it is almost irrelevant that the goods their companies happen to manufacture have the label 'property' attached to them," says Balmer.

"These people are in business just like any other manufacturer, converting raw materials (land and building materials in their case) into goods to sell.

"Some developers make massive amounts of money (the survivors - and they are the only ones one hears about). Passive rental property owners enjoy a much more pedestrian average performance, I suspect."

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