Risk and return, part 1

By Randell Tiongson on November 16th, 2011

Investment:  The commitment of funds made in expectation of some positive rate of return. If the investment is properly undertaken, the return will be commensurate with the risk the investor assumes.

I like the above definition of what an investment really is – it’s not just about returns, it’s also about risks. If the investment is properly undertaken, the risks determines the return and vice versa. Before anyone parts with his hard earned money, he should first understand the relationship of risk and return which is very fundamental and states that:

Low Risk = Low Return

High Risk = High Return

Regardless of how people will claim, the fundamental truth about risk and returns will not change. No amount of financial engineering will alter the fact that returns will always be a function of risks. Further, to say ‘low risks’ does not mean ‘no risk’. I refuse to believe that there is any investment instrument that you can categorize as no risk at all. Recent developments have made the world realize that ‘no-risk’ instruments like debt of first world countries are not really ‘no risk’ at all, in fact many now question if they are in fact, ‘low-risk’ at all.

For purposes of discussion let me give examples of low risk instruments common in the Philippines.

Debt instruments: Savings, Time Deposits, Special Deposit Accounts, Treasuries, Corporate Bonds.  The most common financial investments being transacted in Philippines are debt securities, also known as creditor claims. In essence, one lends and another borrows for these types of transactions.

Savings Account and Time Deposits : Simplest and most common form of a debt investment. A depositor gives money to a bank and the bank guarantees that the money is there after a stipulated period of time; and in return, the bank pays the depositor for letting it use the money for operations (lending, treasury, etc.). Since these instruments carry the guarantee of the bank and most of these are very short term in nature, hence highly liquid instruments (cash or near cash), the interest one gets from these transaction are really low, quite negligible if you ask me. The risk of said investments are really low and if the bank is a reputable and stable one, the risk of capital loss is minimal and none at all if the amount is covered by the PDIC (up to P500,000). The stability of the bank largely dictates the amount of interest it can give so the bigger/stronger the bank is, the lower the interest you can get. Smaller banks need to compete with reputation so they need to entice depositors with higher returns. This is a clear example of risk and return. However, investments in these instruments are relatively safe. Further, the Central Bank ensures that banks are solvent and must meet all its obligations through reserve requirements and other regulatory measures. Unfortunately, even good systems can be flawed and quite a number of ailing banks slips in to the Central Bank’s watchful eye. For savings, the market rates ranges from 0.5 to 1.0% p.a. (yes, per year!) and about 2.0 to 4.0% p.a. for Time Deposits. Smaller banks like Commercial Banks and Rural Banks offer higher rates, from 3.0 to 6.0% p.a. ranges.

Catch for more of these in my next blogs…

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Risk and return, part 1