Tuesday 04 March 2014 by Elizabeth Moran Education (advanced)

Spread risk to protect against cyclical markets

While high returns are attractive, investors need to focus on the risks to ensure their portfolios can remain robust in the worst case scenarios.

What does risk mean? Returns tend to be an investor’s main focus; they help investors assess future income, enabling them to plan future cash flows. But, high returns are offered to compensate investors for the underlying risks involved. The higher the risk, generally, the higher the return.

Exposure to too much risk has the potential to wipe out capital and thus impact future income. To illustrate, consider performance of three different Commonwealth Bank investments: a senior bond (shown as the blue line in the graph), the Perls III hybrid (the green line) and the shares (yellow line). If we invest $100 on the 29 December 2007, we can then track performance throughout the global financial crisis. The returns shown include interest payments on bonds and dividend payments on shares, but not franking as not all investors can claim it. 
CBA graph

The purpose is to show a worst case scenario and the volatility the various investments showed during the crisis. The senior bond shows a fairly gradual upward trend increasing in value. The GFC does not impact its value, enabling investors to sell if needed and recoup their capital. The returns are stable and consistent, in fact boring, but in bond investment we think “boring is good” as it is what protects your portfolio. In this example we use two senior bonds as they are issued for five years and assume on repayment of the first bond, the proceeds are invested in another senior bond.

The hybrid, being higher risk than the bond, shows increasing volatility. In the worst case scenario, an investor selling in March 2009, would have lost approximately 30 per cent of the capital value. The hybrid recovers somewhat, but has yet to catch the lower risk bond in terms of return.

The CBA shares, are the highest risk of all of the securities, and thus show the highest volatility. A forced seller in February 2009 would have lost over 50 per cent of their investment. That is a very high loss of capital in the worst case scenario, assuming the investor has nothing else to sell. It’s worth remembering that all four major banks cut their dividends during the GFC, so investors also lost anticipated income, which may have forced them to sell down capital if they had planned their cash flow needs around the dividends. One of the interesting points to the graph is that, as an analyst, I would rank CBA as the lowest risk company on the ASX. Imagine the sort of risk and thus volatility you would observe in a miner with a single commodity. The shares have now caught the bonds and are outperforming as you would expect over the long term.

Investors should be rewarded for uncertainty due to volatility and that is why shares should offer the highest returns. Equally it is why bonds, being lower risk offer lower returns.

If there is one single rule that holds true, it’s that markets are cyclical. Many professional investors spend much time assessing trends, extrapolating data and using historical facts to try and predict future markets but few are canny or, maybe lucky enough to call the market at the right time. Mangers of large investment funds know the best way to combat uncertainty and to protect capital and income is to diversify investments.


The contents of this document are copyright. Other than under the Copyright Act 1968 (Cth), no part of it may be reproduced or  distributed to a third party without FIIG’s prior written permission other than to the recipient’s accountants, tax advisors and lawyers for the purpose of the recipient obtaining advice prior to making any investment decision. FIIG asserts all of its intellectual property rights in relation to this document and reserves its rights to prosecute for breaches of those rights.

Certain statements contained in the information may be statements of future expectations and other forward-looking statements. These statements involve subjective judgement and analysis and may be based on third party sources and are subject to significant known and unknown uncertainties, risks and contingencies outside the control of the company which may cause actual results to vary materially from those expressed or implied by these forward looking statements. Forward-looking statements contained in the information regarding past trends or activities should not be taken as a representation that such trends or activities will continue in the future. You should not place undue reliance on forward-looking statements, which speak only as of the date of this report. Opinions expressed are present opinions only and are subject to change without further notice.

No representation or warranty is given as to the accuracy or completeness of the information contained herein. There is no obligation to update, modify or amend the information or to otherwise notify the recipient if information, opinion, projection, forward-looking statement, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.

FIIG shall not have any liability, contingent or otherwise, to any user of the information or to third parties, or any responsibility whatsoever, for the correctness, quality, accuracy, timeliness, pricing, reliability, performance or completeness of the information. In no event will FIIG be liable for any special, indirect, incidental or consequential damages which may be incurred or experienced on account of the user using information even if it has been advised of the possibility of such damages.

FIIG provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without taking account of your objectives, financial situation and needs. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision. FIIG does not provide tax advice and is not a registered tax agent or tax (financial) advisor, nor are any of FIIG’s staff or authorised representatives. FIIG does not make a market in the securities or products that may be referred to in this document. A copy of FIIG’s current Financial Services Guide is available at www.fiig.com.au/fsg.

An investment in notes or corporate bonds should not be compared to a bank deposit. Notes and corporate bonds have a greater risk of loss of some or all of an investor’s capital when compared to bank deposits. Past performance of any product described on any communication from FIIG is not a reliable indication of future performance. Forecasts contained in this document are predictive in character and based on assumptions such as a 2.5% p.a. assumed rate of inflation, foreign exchange rates or forward interest rate curves generally available at the time and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. FIIG is not licensed to provide foreign exchange hedging or deal in foreign exchange contracts services. The information in this document is strictly confidential. If you are not the intended recipient of the information contained in this document, you may not disclose or use the information in any way. No liability is accepted for any unauthorised use of the information contained in this document. FIIG is the owner of the copyright material in this document unless otherwise specified.

The FIIG research analyst certifies that any views expressed in this document accurately reflect their views about the companies and financial products referred to in this document and that their remuneration is not directly or indirectly related to the views of the research analyst. This document is not available for distribution outside Australia and New Zealand and may not be passed on to any third party without the prior written consent of FIIG. FIIG, its directors and employees and related parties may have an interest in the company and any securities issued by the company and earn fees or revenue in relation to dealing in those securities.