MONEY BASICS with MARTIN HESSE

Understanding investment risk

THE probability of losing money in an investment differs according to the investment type, generally speaking. We all have some idea of these differences in investment risk. We know that bank deposits, for example, have a minimal degree of risk. On the other hand, shares in a company can be relatively risky.

If you ranked the various types of investments (and “so-called” investments), they would form a spectrum, from very low risk on the left to very high risk on the right.

On the extreme right would be scams parading as investments. A genuine investment is when your money is used constructively to generate profits from legitimate business activity. In a scam there is no intention to use the money to generate growth. Usually, the touted rates of return are unrealistically high to lure the greedy. (See “how to spot an investment scam” on page 18.)

To the left of scams, but still at the far right of the risk spectrum, are unregulated investments. These include property syndications, shares or debentures in private (unlisted) companies, venture capital schemes, and offshore investment funds in jurisdictions with relatively lax financial controls. They are mostly legitimate, but sometimes only border-line so, and sometimes they’re downright dodgy. Furthermore, there are few regulatory controls in place to protect you.

If one of these investments is offered to you, do as much research as you can on the business/scheme/ fund before committing your money, and then only money you can afford to lose. If you are looking for an investment for your life savings, stay well away, no matter how enticing the proposed returns or convincing the salesperson. Moving further left on the risk spectrum, we enter the more comfortable territory of regulated investments. These are legitimate savings vehicles and investments that are regulated by the Financial Sector Conduct Authority or the Reserve Bank.

They can be subdivided into direct investments – where you invest directly in assets such as listed shares, government and corporate bonds, and bank deposits – and collective investments, such as unit trust funds, exchange traded funds and endowment policies, in which investors’ money is pooled in an investment portfolio.

These may be less risky than unregulated investments and you are more protected by legislation, such as the Collective Investment Schemes Control Act. But don’t be under any illusions: there are still major risks attached to many of them.

How can you lose money in a regulated investment? Here are some of the ways:

Bank deposits are not entirely risk-free.

Although the chances are low, the bank could go under, taking your savings with it.

If you are invested in assets such as shares, bonds or property, the values of those assets are subject to short-term fluctuations and occasional market crashes.

If you are invested in offshore investments, there is a risk that the rand will strengthen against the relevant foreign currency, losing you money in rand terms.

If your returns, in whatever you are invested, do not match inflation, you will lose money in real (afterinflation) terms.

Collective investment schemes (unit trust funds and exchange traded funds) are risk-graded according to what they invest in, ranging from low (cash and bonds) to high (equities and listed property).

Broadly speaking, of the equity funds, the general equity funds (those that spread their portfolios over all sectors of the JSE) present lower risk than those that specialise in specific sectors, such as financials, industrials and resources.

Your financial adviser will tell you that, in order to make decent returns over the long term, you need to take on a certain degree of investment risk, and that this risk can be managed.

Safe, low-risk investments, such as bank deposits, are appropriate vehicles in which to “park” your money for the short term, but to receive inflation-beating returns over the long term (more than five years), you must be at least partly invested in the higher-risk assets, such as equities and listed property. Over time, market ups and downs are smoothed out and you stand to benefit from the magic of compounding.

Your adviser will also tell you that a good way to manage risk is through diversification.

If your portfolio is diversified – invested across asset classes – you spread your risk, because the market cycles of the different asset classes tend to be “out of sync” with each other – in other words, when one is going down, another may be going up.

HOW TO SPOT AN INVESTMENT SCAM

While financial regulation gets ever tighter, unscrupulous operators continue to find new ways to con South Africans into parting with their hard-earned money, as happened recently with MTI. WYNAND GOUWS tells you what you should look out for

CHARLES Ponzi, a con artist of the 1920s, whose investment scam involved paying returns using deposits from new investors. | Wikipedia

SOUTH African investors continue to fall prey to investment scams that promise unsustainably high returns, the most recent being Mirror Trading International, involving Bitcoin worth about R7 billion.

It is estimated that more than 230 000 investors have fallen prey to South African scams over the years, losing more than R35 billion. Even though the schemes differ structurally, all of them have a common thread that goes back to the “origin” of Ponzi scheme from the 1920s.

Charles Ponzi was an Italian swindler and con artist in the United States and Canada in the 1920s. He promised investors a 50% profit within 45 days or 100% profit within 90 days, by buying discounted postal reply coupons in other countries and redeeming them at face value in the US. Ponzi was paying earlier investors using the investments of later investors. In the first month, 18 people invested in his company with a total of $1 800. He paid them promptly the very next month, with the money obtained from a newer set of investors. Word spread and investments came in at an ever-increasing rate. Ponzi hired agents and paid them generous commissions for every dollar they brought in. As long as money kept flowing in, existing investors could be paid with the new money invested. This was the only way he could continue providing returns to existing investors, as he made no effort to generate legitimate profits.

While this type of fraudulent investment scheme was not invented by Ponzi, it became so identified with him that it is now referred to as a Ponzi scheme.

His scheme ran for over a year before it collapsed, costing his investors $20 million. Ponzi lived luxuriously: he bought a mansion in Massachusetts, maintained accounts in several banks and bought a Locomobile, the finest car of the time. More than 100 years later we continue to see variations of the Ponzi scheme that continue to trick people out of their life savings. To date the recipe remains the same: the promise of high returns, high commission, initial investors are “paid” with new investor money and, at some point, the deck of cards comes tumbling down, as it is not backed by any proper investment or business model.

Investment scams may be complex and structured to mislead investors, advisers, and regulators. If returns are higher than what is available in the regulated market, alarm bells should go off and this should, at a minimum, lead to further investigation to understand the risks involved.

Wynand Gouws is a wealth manager at Gradidge Mahura Investments.

HOW TO IDENTIFY A SCAM

Insight #1: If returns look too good to be true, it should raise a red flag. Without exception, every scheme offered investors better returns than what is available by investing in regulated financial products. These types of returns are especially attractive to the most vulnerable, retirees who cannot survive on their current income and are looking for some way to enhance their income.

What is a realistic market-related return? As governments are the lenders of last resort, government bonds are a true reflection of a “risk-free” rate. Investors can find the rates of retail bonds on the RSA Retail Bonds website. Currently, the rate is 5.25% a year for a two-year investment. Any rates higher than this would imply some level of risk.

Insight #2: If the return is better than that offered by government bonds, you need to understand the risks. Investments that guarantee a return are often complex and require sophisticated investment modelling and hedging. Most retail investors are not able to assess the ability of an investment provider to deliver a guaranteed return. When a guarantee is provided, the institution offering it should have both the experience and capital to support or deliver on the guarantee.

Question #1: Is the company licensed to offer the product?

You can approach an accredited financial planner without a vested interest in the company under scrutiny to help in determining if the company is appropriately licensed. Alternatively, contact the Financial Services Conduct Authority (FSCA) to confirm if the company is appropriately licensed. Call the FSCA on 0800 203722 or visit www.resbank.co.za

Question #2: Does the company have a track record of delivery?

It is important to consider the company’s long-term track record, ideally over the last five to 10 years. Sadly, some unscrupulous providers fabricate long-term returns. It is therefore important to ensure that reported returns are in accordance with a standard by an industry body. If the returns are not regulated by an industry body, you should ask for audited returns and ensure you are comfortable with the auditors.

Question #3: Does the company have a balance sheet to back its promises?

Any company providing a guaranteed return should have capital on its balance sheet to back its promises. Scrutinise the terms and conditions to ensure the company does stand behind the guarantee, and then ask for a copy of its financials.