Risk-Return in Asset Subclasses

On 01/31/2011, in Investment Strategies, by Jordan Wilson
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Asset classes have general risk-return characteristics.

Cash is low risk, low return. Fixed income is riskier and has higher returns than cash. Common shares have the highest risk and expected return of the core asst classes.

But you need to exercise care when selecting investments within a specific asset class. There can be significant fluctuations in risk-return profiles between investment options in each class.

We will look at a few examples today.

Cash and Cash Equivalents

In general, cash equivalents are considered low risk and low return assets. They are known for their safety and liquidity.

But not all cash equivalents fit this profile.

For example, if you are a U.S. Resident, investing in short-term U.S. Government Treasury bills those characteristics hold true.

High Risk Countries

But the Zimbabwe dollar was also cash prior to its abandonment in 2009. As a U.S. resident investing in Zimbabwe dollars, the inflation and hyperinflation in Zimbabwe made this currency worthless.

Or consider the Argentina peso. In 2001, the government effectively froze bank accounts for a 12 month period. In large part, liquidity and safety disappeared almost overnight. As an added bonus for Argentinians, prior to January 2002 the peso was pegged to the U.S. dollar (USD) at a 1:1 ratio. Then one day Argentinians awoke to find the conversion rate re-pegged at 1.4:1. Within short order that re-pegging had fallen to about 4 pesos per U.S. dollar.

What did that mean?

If you bought a USD 600 television imported from America, it would have cost 600 pesos in December 2001. Less than a year later that same purchase would cost 2400 pesos.

Be careful of countries that have a high risk of heavy inflation or the potential for intentional currency devaluation.

Even Low Risk Countries

If you think it is simply countries such as Zimbabwe and Argentina that need watching, check out the 10 year exchange rate changes between the U.S. and Canadian dollars. Or the USD and the Euro. Or other major currencies. There can be some large swings in exchange rates.

For example, I was living in Switzerland when the Euro was introduced. In 2001, the Euro was usually worth between USD 0.80 and 0.90. By late 2004, each Euro was worth USD 1.36. If you were an American and had bought Euros in December 2001 at 0.88, by December 2004 you would have earned a 55% return.

And if you were living in Euroland and had invested in USD between those years, you would have lost a lot of money.

Not a low risk, low return investment, was it?

Fixed Income

Fixed income securities are generally considered to be higher risk and higher return than cash equivalents but lower risk and return to common shares.

But again, individual fixed income securities can differ from this generality.

Credit Rating

Fitch Ratings classifies the best bonds at Aaa. The lowest investment grade bonds are BBB. Bonds in default are rated at D.

As you should expect, the higher the bond rating, the lower the risk of the bond not paying interest on its debt and in the repayment of principal. The lower the risk, the lower the interest that is needed to attract investors.

For example, let us look at three bonds on January 31, 2011. Each bond has approximately 20 years until maturity.

U.S. Treasury Bonds 5.375% 15-Feb-2031 are rated by Fitch as AAA. The yield to maturity (YTM) is 4.314%

Williams Cos Inc Del Bonds 7.5% 15-Jan-2031 are rated as BBB. The YTM is 6.181%

Brazos River Authority Texas Rev Ref Bonds 8.25% 01-May-2033 are rated as CC (there were no D rated 20 plus year bonds, CC has a high probability of future default). The YTM is 20.975%.

As you can readily see, as the risk of default increases, the yield to maturity required by investors also rises.

Common Shares

Of the three core asset classes, common shares traditionally have the highest risk-return.

But this may not always be true.

Other Asset Classes May Outperform

We looked at some cash returns above. From December 2001 until December 2004 investing in Euros versus the USD would have earned 55%. And that is without factoring in any interest you may have earned on the cash.

What if we compare this cash return to U.S. equities?

On December 3, 2001, the S&P 500 closed at 1158.31. On December 27, 2004, the S&P 500 closed at 1213.45. A total increase of only 4.8%.

Differences Within the Class

Of the three core asset classes, there are the most subclasses within common shares.

Mega cap shares will normally have less risk and return than micro or nano cap companies.

Value stocks may be safer than growth stocks.

Yield shares may be lower risk than capital appreciation shares.

Foreign companies may have more risk than domestic.

Defensive stocks may be less risky than cyclicals.

Mining companies may be riskier than utilities.

Or, depending on economic conditions, the opposite may be true.

The individual common shares you choose to invest in will have a different risk-return profile than common shares as a whole.

That is why investors often diversify through multiple subclasses, so as to spread the risk.

That is also why some investors try to time the markets. As one subclass begins to outperform, more capital is allocated to that subclass and away from underperforming subclasses. But, as we have discussed previously, the ability to time the market is not easy and the transaction costs can be steep.

Okay, that was a few quick examples of how investments within a specific asset class may differ significantly from the general profile for the class as a whole.

There are many other examples possible, but this gives you an idea as to what I am saying.

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