David French | 16/03/2009 4:32:50 PM

Successful investment is about accurately assessing risks and ensuring that you are compensated for the level of risk that you take. There are several types of risk which range from the risk of losing your investment, to losing the purchasing power of your investment through the effect of inflation. This article discusses the risks associated with some financial products and strategies.

Money under the bed

Aside from the risk of burglary, inflation means that the value of the “stash” reduces every day. Most insurance policies cover for only a relatively small amount of cash left in the house, and have strict conditions on claims. Don’t do it.

Government and corporate bonds

A bond is basically a loan you make to the borrower. The borrower might be the Government, a company or an individual . Ultimately the safety of a bond depends on the strength of the repayment guarantee and the quality of the borrower. Australian Government bonds are rated very highly however extensive financial experience is needed when assessing the creditworthiness of non-government issuers. These instruments often pay just a little more than the inflation rate, so the purchasing power of the money is maintained, but unless you are a sophisticated and successful bond trader, growth in the investment’s value is normally limited.

Deposits at a Bank, Building Society or Credit Union

At the time of writing, deposits at these institutions are not protected by the Government. If there was a “run” of withdrawals then the Reserve Bank can step in and provide funds to satisfy depositors, but the business itself might be allowed to fail. Both federal and state governments have assisted deposit holders (or policy holders) when individual financial institutions have failed. Governments realise that it is important to maintain confidence in the financial system. The returns on these investments may or may not cover inflationary losses, especially when fees are considered.

Shares and property

These investments are more risky in the sense that their price moves up and down with market conditions and there is no promise that you will get your money back. A portfolio of assets can be designed to reduce the risk as will proper research into the investments. Over long periods these asset classes have historically performed best, however investing in a company that goes broke is not wealth-enhancing. Having an office tower built in front of your investment property with the prime view can have similar results.

Unit trusts and managed funds

These investment vehicles effectively make investments on your behalf. Your money is invested in assets owned by the trust for your direct benefit. Theoretically your money is as safe as the underlying investment (property or shares for instance), but you need to be mindful of the powers given to the manager of the fund and the integrity of the trustee (these can now be combined as a responsible entity). Problems can arise when a manager with very broad powers moves unexpectedly from very conservative investments to risky investments, or if the responsible entity turns out to be shonky. In a well-run fund, even if the manager fails, your assets should be left intact.

Insurance bonds

Unlike managed funds, investments are not made for your direct benefit. Your money is pooled with that of other investors and the pool is owned and run by the insurance company. The insurance company commits to paying you an agreed return. If the insurance company goes belly-up, then you have to wait in line with all the other creditors. Some of the best-known insurance companies have come under the microscope regarding deals that have threatened their ability to pay owners of insurance bonds and other creditors.

Tax driven investments

Olive plantations, emu farms and other creative money siphons pop up round tax time. These investments are generally highly risky and often come with no real prospect of getting your money back, let alone making a profit. You may get a tax deduction for your investment, but if the project fails, the most you will get back from the tax department is about half your investment. If you are not on the top marginal tax rate the tax shield will be less. If you are doing this to “shaft” the tax department, then why not give to your favourite charity. At least the good feeling that comes with the transaction is certain.

The Investment Collective (AFSL 471728) is a non-aligned financial planning and investment firm specialising in providing tailored financial and investment advice for individuals and small business. Capricorn Investment Partners Limited's services include financial planning, share trading, portfolio management, insurance broking and self managed super fund administration. Additional information on services provided by The Investment Collective Limited can be found by following this link. Readers are reminded that this document has been prepared for general information purposes only, and any advice contained herein has been prepared without taking into account your financial objectives, situation or needs. Readers are advised to see their financial advisor prior to acting on any general advice.

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