What is Investment?

In its basic form, an investment means entrusting the use of your money to another person or entity for utilisation of that money to generate a return, at a rate better than you are able to generate yourself. In taking more risk in this exercise, you should expect a greater return on your investment and this represents the basic premise of investment – 

'The higher the risk you accept (in whatever form that risk takes), the greater the return you should expect in the long term as reward for it's acceptance.'

No investment is without risk, although degrees of risk vary. The different types of risk that an investment can be subject to are described later in this note. 

Investment Time Frames

When we discuss the type of investor you are we often refer to time frames, these are defined as follows: 

Short Term - at call to 2 years
Medium Term - 2 years to 5 years
Long term - 5 years and beyond 

We consider your “Investment Risk Profile” in the context of the Long Term only. Funds required within the short term in particular and possibly the medium term require special consideration and should be treated differently from your long term strategy.

Risk

Standard Risk Measure

We have adopted the Standard Risk Measure, which is based on industry guidance to allow investors to compare investment options that are expected to deliver a similar number of negative annual returns over any 20-year period (as outlined below). 

The Standard Risk Measure is not a complete assessment of all forms of investment risk - for instance, it does not detail what the size of a negative return could be or the potential for a positive return to be less than an investor may require to meet their objectives. 

The Standard Risk Measure consists of seven risk labels: 

• Very Low: A negative return expected to occur less than once over a 40 year period. 
• Low: A negative return expected to occur once over a 20 to 40 year period. 
• Low to Medium: A negative return expected to occur between once and twice over any 20 year period. 
• Medium: A negative return expected to occur two to three times over any 20 year period. 
• Medium to High: A negative return expected to occur three to four times over any 20 year period. 
• High: A negative return expected to occur four to six times over any 20 year period. 
• Very High: A negative return expected to occur six or more times over any 20 year period. 

We use these descriptors when considering any form of investment. 

Forms of Investment Risk

Risk manifests itself in volatility of the value of an investment. Risk can result in sharp falls as well as sharp rises in values of investment and can therefore be both detrimental and beneficial to the investor. 

In considering particular types of risk, we comment on the downside of the risk issue, but you should consider that for each downside possibility, there is also an upside possibility. 

There are a number of forms of investment risk. Common forms are as follows: 

• Currency Risk: The risk that an investment can change in value in line with movements in the value of the Australian dollar relative to other currencies. Losses arise when the Australian currency appreciates in value against another. 
• Mismatch Risk: The investments chosen may not match the appropriate timeframe for use of the funds. This effectively means that funds are either not available or have declined in value at the time they are needed. 

This risk will apply to any investment for which the timeframe of the intended use of the funds does not match the suggested timeframe for that investment, for (extreme) examples: 

• Investing in cash for provision of retirement income for a 25 year old. 
• Investing in shares when funds are required for purchase of goods or services in next six months.

• Inflation Risk: The real purchasing power of money may not keep pace with inflation. Over the long term, it means a significant reduction in the goods and services that could be purchased compared to today by the same pool of funds. 
• Interest Rate Risk: For investors relying on fixed rate investments, funds may have to be reinvested at maturity at a significantly lower rate if interest rates fall during the term of the investment. Further, the market value of securities can decline in value before maturity after a rise in interest rates. 
• Market Risk: Movements in the market mean the value of investments can fall sharply – and sometimes suddenly – with the advent of economic “shocks” or bad news. This impacts all securities in that market regardless of specific issues or impact of such news to a single security. 
• Timing Risk: Anticipating market rises and falls can be extremely difficult because no two economic cycles are the same. This risk can result in an immediate drop in value of an investment due to an unexpected drop in the market as a whole immediately after investment and arises when moving from securities with fundamental different risk characteristics, such as from a cash investment to an equity investment. 
• Specific Risk: Whereby a portfolio as a whole can be disproportionately affected if a single investment goes badly. Thus, if a small number of large investments are held, the portfolio is more subject to the fortunes, good and bad, of those individual investments. 
• Liquidity Risk: Meaning loss of access to funds via sale of the investment quickly at a cost or needing to accept a significantly lower value for it should funds be required urgently. 

In extreme cases it is the lost ability to convert securities back into cash for an indefinite period. 

• Credit Risk: Applies to debt-type investments such as term deposits and debentures. Arises when the institution the funds have been lent to is unable to make the required interest payments when due or repay funds at maturity – they effectively “default” on the promise to pay interest and/or capital when required. 
• Geo-Political Risk: Whereby investments are impacted by the economic circumstances or the political actions (or inaction) of a particular country or region.

Major Asset Sectors

It is possible to invest funds in any number of different types of investments or schemes. These can be broken down into various categories. 

• Traditional “Income” Assets – Such as cash or fixed interest securities. These investments typically provide their return via interest payments and as such provide an “income” return. The value of such assets is fixed or relatively stable and hence is described in the broad category of “defensive” assets. 
• Traditional “Growth” Assets – Such as shares generally listed on public stock exchanges (both Australian and International). In this case, the exact value is always uncertain, and can be subject to fluctuation over a wide range in very short periods of time. his also includes “Real” Assets – such as property, infrastructure and natural resources. This can be achieve through direct purchase of such assets, or alternatively through listed and unlisted trust vehicles. These investments are expected to grow in value over time and hence are described in the broad category of “growth” assets. They will provide varying levels of income depending upon the specific type of investment, but in extreme cases can provide no income return at all. 
• Alternate Investments – being assets that do not fit into the traditional broad asset definitions. This may include private equity, hedge funds and structured investments and commodities. These have special characteristics which make them subject to individual assessment of risk and require a high level of investment review given the complexity typically associated with them. These investments are often considered “hybrid” investments typically providing some combination of traditional asset categories of defensive and growth. 

• Speculative or “Opportunistic” Investment – These are investments where there is a reliance on a certain outcome or event to generate a return, usually significant. It is akin to gambling, as it is reliant on an outcome which will have varying degrees of predictability. These investments are not recommended by Arc Financial Solutions or its representatives.

Investment Characteristics

The table below sets out the characteristics of each of the major asset sectors.

Loss vs Decline in Market Value

A decline in value of an investment should not necessarily be regarded as a loss. Loss infers permanence and the inability to recover that loss. Many investments can suffer a decline in value, which may only be temporary due to subsequent recovery in values. 

A “market value” of an investment represents the price a person is willing to pay for an investment at a point in time, and can be influenced by a number of factors. Market value is commonly used to value investments, particularly shares and other commonly traded securities. 

However it may actually be difficult to establish a value for an investment, for example in the case of a property. While people may have an opinion as to the value of property, by comparison to other similar properties in the same area or through a formal valuation report and opinion, ultimately a property’s value is only determined each time an exchange of ownership occurs. 

Assets, including shares and properties will have an underlying worth or value, at least in a theoretical sense. 

As the experience of 2008 in particular and many other episodes in the past show us, the market value of an investment may not actually represent an asset’s true or “real” value. They merely reflect the most recent trade of that investment. As shares have many more trades than property exchanges they appear to have a more volatile valuation. 

Patience has seen recovery of values and a return to positive results over a period of time for those investments. 

However, if you need to sell an asset at a time when the market value is depressed, you will convert a “decline in market value” as a temporary issue, to a “loss” in the permanent sense. 

When investing in securities that are regularly valued by the market you need to recognise that: 

• The value in the market may vary from the “true” value of the investment; and
• You should not hold funds in a market where value can change significantly and quickly if you know that you will have a need for using those funds in the short or medium term. 

This is why it is critical to examine your time frame when you are considering the investment of your funds. 

ARC Financial Solutions Investment Principles

There are different views of investment, and there is not always a correct answer. Investment is an inexact science as the outcomes of investment markets are determined by a combination of logic and sound argument and the actions of humans who are often driven by the irrational emotions of greed and fear. In our view:

• Logic prevails in the long term;
• A higher level of short term risk should generate a higher level of return in the long term; and
• Emotional behaviour is unpredictable.

As a result there are a number of investment principles to which we subscribe:

• Matching investments to your time frame is critical.
• The major determinant of your long term return is the “asset allocation decision” – how much is allocated to growth investments such as shares and property in favour of income investments. 
• The allocation of your investment to the various asset allocation sectors is determined by the assessment of your “Investment Risk Profile”, balancing the conflicting needs of minimising risk and maximising return and your personal preferences and needs. 
• Investment markets are unpredictable in the short to medium term (anything up to 5 years). 
• Equity markets reflect underlying growth in economic conditions. While we believe that economies can continue to grow, equity markets will ultimately reflect this. Hence, in our view the major drivers of growth in a portfolio will be equity investment, both locally and globally. 
• Maintaining your investment strategy is the most reliable way to minimise short term risk and maximise long term return. Changing asset allocation in the short term can be a very risky practice. 
• Diversification is the most effective way of minimising risk for a given investment profile. This applies to diversification across asset sectors, within asset sectors and the number and styles of fund managers appointed. 
• We believe in professional management. Therefore and where ever possible, we recommend “multi-manager” and “index style” funds monitored and selected by well regarded asset consulting firms and investment research houses. This approach also simplifies and typically provides savings in terms of administration costs. 

We follow these principles in providing investment advice to you.

What is an Investment Decision

There are two aspects of the investment decision, being: 

• What is the appropriate Investment Strategy – in terms of the allocation of assets to different investment sectors of growth (shares, property) and income (fixed interest securities, cash); and
• How is that Strategy implemented and then managed on an ongoing basis. 

These decisions are best addressed in the above order.

A Sensible Investment Strategy

Determining and maintaining a successful investment strategy is a matter of taking into account many variables and putting them into effect in an arena fraught with uncertainty and commentary from just about every angle. The determination of what is an appropriate investment strategy for your position needs to take into account: 

• Your time frame for investment – the longer the time frame the more important the average long term return rather than short term return over a few months or even years. 
• Your personal risk profile – what are the things that are really important to you in the delivery of an investment result and what implication does that have for the objectives you have in this plan? 

One of these factors cannot be considered without taking into account the other. 

Our role is to make an assessment of your risk profile based on our discussions with you and make an appropriate recommendation for you. 

Definitions of the various risks and the various profiles used by Arc Financial Solutions are contained on the following pages.