Finance Your Budget How to identify the risks lurking within financial products

How to identify the risks lurking within financial products

Risk return
It's imperative you do your homework before leaping into any investment. Photo: Getty
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Choosing where to invest your hard-earned income depends on many factors, including your appetite for losing money (aka your risk/return profile), and the specific risks associated with buying different financial products.

If you’re new to investing, you need to know there are four different investment types – or asset classes – that typically make up an investment portfolio.

These include cash, Australian or international fixed interest, property, and Australian or international shares – and it’s your job to understand the particular risks associated with buying them.

As a starting point, all investors need to get their head around what’s called the investment risk curve (see below).

It may sound fancy, but it’s just a simple way of showing you how risks and returns are directly linked. For example, cash – the asset with the lowest returns – sits at the bottom of the curve and has the lowest risk.

It is asset allocation, rather than actual investment products, which distinguishes high returns from low returns.

Think of it this way: Defensive assets, like cash and fixed interest, offer lower returns in exchange for less risk, while growth assets – property and shares – do the exact opposite.

Where are you in the queue to get paid?

A snapshot of the four investment types and their risk characteristics will, says Andrew Zbik, senior financial planner with Omniwealth, reveal where you stand in the pecking order to get your money back if your investment goes pear-shaped.

“It pays to understand, for example, the different risks between, say owning direct shares in a bank versus a hybrid security (a more complex corporate bond) that the same bank might issue,” Mr Zbik explains.

  • Cash: Includes bank deposits, cheque accounts and cash management trusts. With the lowest level (interest-only) returns, cash is suitable for investors with a short-term investment outlook or low tolerance for risk. Cash deposits in banks, building societies or credit unions are guaranteed up to $250,000 by the Australian government
  • Fixed interest: Includes income-producing assets (like government bonds, fixed-term deposits, and mortgage trusts). While it’s more volatile than cash, fixed interest is a relatively stable asset class, and you receive your initial investment amount back at the end of the set term
  • Property: Including residential, industrial and commercial, it’s higher risk than fixed interest, but can provide tax-advantaged income from rent received, plus the potential for capital growth (or loss)
  • Shares: You take a financial interest in a publicly listed company, and can share in its profits (often through dividends) and future capital growth (or loss) when the share price moves along with market sentiment. This is the most volatile asset class, and you could potentially lose your initial investment if a poorly managed company goes bankrupt. But historically, shares have achieved, on average, the highest long-term returns.

Do your homework

But to complicate matters, Mr Zbik says it’s important to remember that not even investment products within the same asset class are made equal.

That’s because different products can carry their own unique risks and opportunities.

He cites the specific risks associated with, either syndicated property, exchange-traded funds (ETFs), active-managed funds, or newcomers like fractional property investing and other micro-investment products as a case in point.

It’s true, virtually all financial products are required to provide what’s called a Product Disclosure Statement (PDS).

Trouble is, given that they’re typically 50- to 120-page documents, written in institutional and legalese jargon, investors struggle to read, let alone understand them.

With that in mind, Mr Zbik recommends going straight to any PDS’s executive summary page, where there should be a plain-English explanation of the investment and its benefits.

From there, he suggests going to the small print for an insight into fees, commissions, and an explanation of the underlying risks.

Don’t buy if you don’t understand

Deciphering these documents is one reason, Mr Zbik adds, why it makes sense to hire financial planners.

Given that financial products are complicated by nature, he suspects most people would benefit from being walked through the pros and cons of buying from the ever expanding and increasingly complex range now available.

“Guiding clients into investment products is less about risk per se, and more about seeing if they have the appetite for volatility, as many investors may not have the stomach for short-term losses,” he says.

The investment risk curve

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