Investment Basics

Financial decisions are bound by three immutable factors; Risk, Return and Time. Understanding these core principles allows for a more effective and disciplined approach to the investment or risk management process. The central theme is that no "free lunches" exist in the financial markets over the medium to longer term. To earn an above average return a higher than normal risk exposure must also be taken. The forces of so called "arbitrage" ensure that all financial opportunities reflect this relationship of risk, return and time.

Risk:
Companies, financial executives and individual investors face a number of key financial and operational risks. These major threats need to be identified with some contingency plan put in place to deal with the potential adverse outcomes. Obviously the nature of the risk depends on the activities undertaken. For example, exporters to the United States face a direct currency risk if the AUD/USD appreciates unexpectedly. This move would reduce the Australian dollar value of USD sales and hence profitability. While an Australian manufacturer who supplies the domestic market faces an opportunity cost if interest rates fall and they have already locked in their borrowing costs via fixed rates. For the individual investor with a share portfolio, they face the prospect of a capital loss if the stockmarket falls and the individual shares in the portfolio decrease in price relative to their initial purchase price.

Financial exposures:
All holders of financial assets such as bank bills, bonds or equities are exposed to adverse changes in the price of the securities or positions in their portfolios. These price changes can be driven by a range of factors such as increases in interest rates, unexpected developments in the economy such as high inflation or a legislative change that impacts on the profitability of a particular industry.

Volatility:
Financial market practitioners use the term volatility to define the relative risk of a given asset. A security with a high level of price volatility is said to be more risky than another with lower price volatility. The main constraint facing practitioners is that the volatility of a security price is not directly observable. To overcome this constraint volatility is assumed to be estimated by the statistical concept known as standard deviation. Standard deviation in broad terms quantifies the general level of variation of the security price from some central mean.

Credit & defaults:
An important risk that needs to be identified when dealing with business counterparties particularly when lending money or buying the bonds issued by companies. The most extreme example of credit risk is where the counterparty becomes bankrupt and defaults on the original loaned capital. Organisations such as Moody’s and the Standard and Poors ratings agency provide a service that attempts to measure these type of bankruptcy risks. The higher the bankruptcy risk the lower the rating. At one end of the scale, debt issued by Governments is seen as virtually default free whereas the debt of a medium size manufacturing company is viewed as less likely to be classed as so called investment grade quality. A related issue is Political or Country risk. This risk mostly relates to investments in emerging markets or developing countries. It was the major issue of 1997/98 with the Asian economic crisis reiterating the message that investing outside the major industrialised nations carries with it an additional level of risk.

Operational threats:
A broad class of risks that cover areas as diverse as; legislative changes to the operations of a particular business area that decreases the long term profitability of a company, to the new currency exposures incurred by moving into new overseas markets and or a competitor gaining a technological advantage that decreases market share opportunities. These type of forces along with the increasingly rapid rate of change in the business environment have made information flows a valuable business asset.

Return:
The return from an investment or business activity is generally measured relative to an initial purchase price, funding or capital cost. It can be measured as a percentage gain over the initial price or in terms of a straight profit and loss. The actual net accrued increase in value can be summarised by the income or cash flow received during the life of the investment as well as any net capital gain minus the costs and taxes associated with the investment.

Return vs Risk Profile:
The central rule of investing and the financial markets is that if an opportunity offers a higher return it must also carry a higher risk profile compared with an alternative asset that offers a lower return. The forces of arbitrage, the simultaneous buying in one market and selling in another, ensure that securities with the same payoff characteristics have the same price across different markets over time. In other words, no matter how complex the structure of a given deal or investment opportunity, it is impossible to remove the underlying correlation of a high return with high risk. This relationship ensures that the available funds are allocated among the opportunities on offer according to their expected risk profiles.

Example of Risk / Return tradeoff:
In keeping with these principles the market for Venture Capital offers investors a higher return / higher risk profile than investing in the top 50 companies who have a mature earnings history.

Time:
As in all endeavours time can be both friend and foe. The time horizon over which an investment is held is critical to the ultimate outcome. Time plays a crucial role in all financial decisions. The longer an investment is held the more opportunity there is for both loss and capital gain. By definition the longer the time horizon the greater the uncertainty about a particular outcome. It is therefore critical that the time horizon is integrated into the decision making process.

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