Asset classes - why risk equals return

When considering how to invest your superannuation in different types of investments (called asset classes) you will often be warned that chasing higher returns involves taking more risks.

At a glance

  • Different investments (asset classes) have different levels of risk and return.
  • The more volatile an asset is, the riskier it is.
  • Historically, the riskier an asset is, the higher the average return over time. This may have changed.
  • A way to mitigate this risk is to diversify and/or use dollar cost averaging.
  • Investors need to understand their investment style.

It's important to understand this relationship; it will help you recognise the risks and returns you can expect from different investments in the short and long term.

Asset class describes a type of investment, such as shares, property, fixed interest and cash, with new types appearing e.g. alternative investments. These can be further broken down e.g. international shares versus Australian shares.

Risk and volatility

Each asset class has a different level of market volatility. And the more volatile an asset is, the riskier it is. Each asset has its own characteristics which affects its volatility and risk.

The table below describes the risk factors associated with each asset class.

Assets and their risk factors

Asset class Description
Shares Shares are generally classified as a growth asset and include Australian shares and international shares (which may be hedged or unhedged to the Australian dollar).

Specific risks relating to the shares of individual companies include industry risk factors as well as disappointing profits and dividends, management changes or reassessment of the outlook for the company or industry.

International shares are also influenced by global economic trends and individual country risk (e.g. political environment and laws). Unhedged international shares investments also carry currency risk. Capital gains may occur when the Australian dollar depreciates relative to other currencies and capital losses may occur when the Australian dollar appreciates.

Alternative assets Alternative assets can be broadly classified into growth and defensive asset classes. Alternative assets (growth) have higher expected returns and risks with associated greater levels of volatility that result in a higher probability of negative return over a short-term investment period. Alternative assets (defensive) offer relatively stable income streams and price volatility that is generally lower than that of growth assets. Thegrowth and defensive alternative assets offer low correlation to mainstream asset classes.

Alternative assets may include non-traditional liquid investments that target positive and uncorrelated returns under all market conditions by utilising strategies and investment instruments such as short selling, gearing and derivatives. Alternative investments such as private equity (an unlisted company/enterprise), venture capital (associated with new business and subject to a more than normal degree of risk), mezzanine finance (a form of unsecured debt finance) and other private placement debt often present higher risks than traditional investments. Alternative assets can also include other exposures such as infrastructure debt or equity and commodities and trading strategies.

Property Property is generally classified as a growth asset and covers listed and direct property, and global and Australian property. Risks of property investing include vacancies, locational factors, unprofitable property development activities, declining property values and realised losses when properties are sold. Property investments may be held in a trust listed on a stock exchange, and in that case, will also attract some of the risk associated with share market volatility. Property development may also be undertaken where the risks include delays in obtaining required approvals, construction risk, leasing risk and market risk.

Direct property is also subject to liquidity risk and global property is also subject to international investment risk (including currency risk).

Fixed interest Fixed interest is generally classified as a defensive asset and covers both Australian fixed interest and international fixed interest. Although fixed interest investments normally pay a set amount of interest income over time, market values can fluctuate due to changes in interest rates. Generally, the value of your investment will fall if yields rise, which could result in capital losses. Fixed interest investments are also subject to default risk, and it is possible the investor will not receive interest payments, the repayment of invested capital, or even both. Fixed interest investments are sensitive to movements in the credit spreads, being the yield margin above a risk free asset yield required to compensate investors for credit risk. Generally, the price of fixed interest securities is adversely affected by increases in credit spreads.

Certain types of fixed interest investments may also be subject to liquidity risk. International fixed interest investments may also be subject to international investment risk (including currency risk).

Cash Cash is generally classified as a defensive asset. Historically, longer term returns of cash have been generally lower than for other assets. In some cases, cash returns after fees and charges have not kept up with inflation over the long term. Cash may include "cash like" assets such as corporate bond securities and derivative instruments. Such assets may suffer loss of value, leading to negative returns.

History

This chart shows how different asset classes have performed over a 30-year period.

Asset class returns over 30 years

Source: AMP Capital Investors, Bloomberg, Factset

This illustrates how high-returning assets, such as Australian shares, deliver the highest average returns, but they also have a much wider range between its peak and trough than bonds or cash - which reflects their relative volatility - and the traditional relationship between risk and return.

It also shows how all defensive assets, such as Australian bonds, are averaging rates of return just below international shares and comparable to Australian listed property trusts. The global financial crisis of the late 2000s may have changed the old risk and return relationship for international investments and highlights how strong the Australian economy has grown relative to the world.

Remember, past performance is not a reliable indicator of future performance.

How to reduce risk

Some of the best ways to reduce these risks are to:

  • diversify your investments across a range of asset classes. Your investment portfolio is still likely to experience some volatility, but not as extreme as the price changes within a single asset class.
  • Use dollar cost averaging which will spread your investments consistently over time.

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