The basic concepts & the basic products

Arguably the most important factor to get your head around is the concept of risk. What is risk, and how can we measure the degree of risk inherent in a particular investment?

Risk is defined as the volatility and unpredictability of returns and we measure it by calculating the deviation from the norm. This means, instruments that behave considerably differently from the average are perceived as possessing higher volatility and therefore a correspondingly higher risk. The more volatile and unpredictable an investment is the higher the risk it carries with it.

Consider a share in a single company, it obviously carries more risk than a basket of 20 different stocks - hence the birth of the mutual fund or unit trust as a means of spreading risk. This introduces the concept of diversification. The spreading of risk between different areas of investment, be they geographic (investing in different countries), by company, by industrial sector (e.g. manufacturing or retail) or by asset class. The four main asset classes are cash, stocks, bonds and property and ideally an investor's portfolio should contain all four in proportions dictated by his or her overall risk profile.

Another factor that must be considered is the base currency for investment. Will you remain in Japan or will you return to your home country? Think, which currency is the most relevant in your particular circumstances? This is your base currency, and as I am sure you already know, currency values do fluctuate. The major currencies for investment are the US Dollar, the Euro and the Japanese Yen. The British Pound should only be considered if you intend to live in the UK at some point in the future.

The final concept I would like to introduce is time scale. Again, closely this is linked with risk. It is important to ensure a good investment horizon if you are to make a reasonable return. Unless you are a speculator, who is prepared to trade in and out of the markets, I recommend that money should be kept in cash on deposit for periods of less than two years. Usually a minimum of 3 to 5 years should be allowed in order to make a reasonable profit. A basic rule, the longer left the better, as a longer-term investment horizon will actually lower your overall risk as you can accept greater market volatility. If your investment horizon is short-term you should correspondingly opt for lower risk investments and perhaps lower returns.

So how much risk are you willing to take with your money? It's an old cliché but the main emotions that drive investors are greed and fear; the attraction of large profits balanced by the spectre of capital loss.

What's available?

Cash On Deposit
Cash on deposit in your base currency carries no risk, assuming that it is placed in a sound institution. The interest that you will receive on your savings will be dictated by the prevailing interest rates in the country whose currency you hold. You may be able to improve on the rate received by putting your cash on call deposit. Typically this would be for 30, 60 or 90 days. You may also consider the Managed Money Fund (MMF), where the fund's manager basically chases the best deposit rates around the globe in order to improve on cash deposit rates. Again this form of investment carries no risk.

With-Profits
The next step up from cash, with minimal risk to your capital is the British With-Profits style of investment. Offered by several large UK based Life Assurance companies, the initial capital is guaranteed and then the fund grows through the addition of annual bonuses, which once added cannot be taken away. Usually denominated in the US Dollar, the Euro or Sterling, With-Profits are designed to offer investors a secure low-risk alternative to direct exposure to the equity markets. The returns comprise two elements, the first is an annual dividend declared in advance which is linked to cash rates and a terminal or claims bonus, which is typically paid annually to reflect the medium to long-term performance of an underlying fund. This fund will comprise all of the major asset classes mentioned earlier in the article.

The history of With Profits stretches back over 150 years and they represent the major proportion of all UK investments for pensions and savings. They are highly recommended for the conservative investor prepared to allow a 5 year time frame for investment. As for returns, over the past 20 years these have averaged over 5% above bank deposit rates.

Mutual Funds
The most well known product available for investment in the offshore market place is without doubt the mutual fund or unit trust and the risk associated with this kind of investment depends on the underlying asset class mix together with the investment manager style. The most common type of fund is the equity fund and there are literally thousands available. Stocks and shares are inherently subject to the vagaries of the world's stock markets with no capital guarantees generally available. Dependent on where the manager invests, risk can vary between medium (a well-diversified basket of shares in a major market such as the USA) to speculative (Indian company shares). Moving back down the risk scale, there are also managed funds that invest in a mix of stocks and bonds (government debt) and also pure bond funds where the risk of capital loss should be very low.

Hedge Funds
In recent years we have also seen the emergence of the Alternative Investment Strategy, probably better known as the Hedge fund, into the retail market place. Previously only available to institutions and high net worth individuals these funds employ almost as many investment strategies as there are fish in the sea. This can range from aggressive high-risk strategies to low-risk defensive management styles that can be very useful in diversifying risk within an investor's portfolio. The buzzword Market Neutral is often used to describe the latter style where the manager aims to make money in either rising or falling market conditions. Highly recommended in times of high volatility.

Internet Trading
For the more adventurous amongst you there is also the direct purchase of stocks over the Internet. Although a high-risk strategy, there can definitely be a place for a smallholding of say 5% in most peoples' portfolios if you are prepared to accept the volatility.

In my next article I hope to be able to give you some options for investing in the current market conditions, which I am sure you will be aware have been very tough for investors.

Ivan Doherty
ipd@ifg-asia.com

Ivan Dohety MLIA (dip) is Chief Operating Officer of IFG Asia. Part of The IFG Group PLC and registered with the Ministry of Finance in Japan to give investment advice.

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