Risk And Return Of Assets
Welcome back to another article on investment newbie with me who is definitely not a professional. This article is intended to help or guide other people who are in the same boat as me and want to understand more or recap about risk and return. For those people who are expecting me to release articles on tech or programming stuff, please bare for a while more. Thanks!
Now, this article was initially inspired by how inflation is rampaging. Almost every time I read the news, there would be news about different consumer goods or services prices being increased. These are then followed by people’s comments about how salary is the only thing that is not increased as a joke, which is strikingly true.
However, having been submerged by financial articles for quite a long while now, the topic of inflation is almost like a norm to me that I didn’t really think about it seriously, because of how often people talk about this.
One day, I chanced upon a video that was talking about risk and return of different assets. The example of the real, solid mathematical calculation of the different assets or rather, cash, striked me so hard that it makes me appreciate and take inflation more seriously. Hence, here I am trying to share it with my readers so that you become even more considerate whenever you want to deal with money or your cash, and also to understand better why a lot of people often say don’t let your excess cash idling around.
P.S. I also wrote about the habits to get to financial independence that might help to explain working your idle cash.
Inflation
What is inflation? In general, it is the increase of prices of consumer goods and services. If you are trying to buy KFC and you suddenly realise that the usual chicken meal has been increased by $1, that can be because of inflation. Now, there are different types of inflation but we are not going in-depth about it here as it is just an example to determine how the cash loses value.
So, what’s the big deal if food prices are increased by $1? Then maybe your oil prices are increased, followed by your utility bills, then your transportation prices, etc. Suddenly everything becomes more expensive.
Then, the reality hits harder when you realise that your salary remains the same but you have to pay more for your daily necessities. It might still seem fine for people who are earning a comfortable amount, but at this point, those who are poorer than us are actually already feeling it the most.
Cash
Holding cash is not a safe investment or way or whatever as it is vulnerable towards inflation as can be seen from the previous example, or the current economic situation.
Cash might seem like a totally safe place as nothing can affect it, no volatility can beat it like how you might lose your sleep in the stock market, but that is actually a false sense of security. There was actually news on how someone stored the cash in a biscuit tin but found out that it was eaten by bugs. Yes, not even that is safe!
So, anyway, inflation rate can really eat away at a certain percentage your cash value every year without you even realising. That’s the dangerous part as I feel that just because you are earning comfortably, you can still spend regardless. You might eventually save less and this can jeopardize your future (retirement).
This is why a lot of people say to work your cash as assets in general should be able to hedge against inflation. Take for example, the stock market, the prices would increase and that means your investment money would increase too. In this case, your cash value would lose less to inflation as compared to having your cash not doing anything. I will show you the calculations later.
Risk and Return
Apparently, there is this thing that tells about the hierarchy of risk investment. The theory is that as the investment gets riskier, the annual return or the amount you can gain becomes higher. At the lowest tier or level, there is cash. The lower the level, the safer the asset is. The higher the level, the riskier it gets.
The general progression is usually cash, short-term debt, long-term debt, property, high-yield debt, and then equity.
Cash is at the bottom because it is considerably safest as there is no risk whatsoever that is associated with it (factoring out inflation for now), as compared to other assets. Take for example, government or corporate bonds would risk you losing money if they default. The stock market is just so volatile that you can lose your money if you go YOLO and just invest in meme stock. What about cash? It sits pretty in your bank account that is safe from any volatility that you can think of.
What if we factor in inflation rate? Let’s see.
The hierarchy of risk investment is known to be something like this:
Cash < Government Bond < Corporate Bond < Stocks < Alternative Investments
Imagine here are the returns for each of them:
Cash: 0%
Government Bond: 3%
Corporate Bond: 5%
Stocks: 10%
Alternative Investments: 20% (Insert any risky one here)
Looks good eh? Now, what happens if there is an inflation rate of 3%?
Cash: -3%
Government Bond: 0%
Corporate Bond: 2%
Stocks: 7%
Alternative Investments: 17%
If you noticed, I have deducted each of the asset’s return by 3%. Why do you ask? This is the real return or the real money that you get after factoring in inflation. Remember, you cannot run away from inflation.
If that is not scary enough, imagine the inflation rate is 15% (I really hope that won’t happen). Suddenly your cash is the only asset that loses the most.
That is why people often say to not keep too much cash as they become useless when inflation hits hard. Its value decreases the fastest.
When I first saw the calculation, I was surprised by the realisation that the impact is actually greater than we thought. Just because we heard about inflation a lot, does not mean we can underestimate it. However, as long as you are aware, I think that should be fine.
Cash is trash — Ray Dalio
I often heard about that phrase from Ray Dalio. He is well-known for his all-weather portfolio. This portfolio is meant for balance. When one thing goes down, the other goes up. Hence the portfolio performance won’t be significantly affected. If you are thinking about investing, maybe you can look at his.
If you do plan to start investing, you can perhaps take a look at what to do before you start investing. You might also want to know more about the different assets and investment vehicles too.
Anyway, Ray Dalio suggested that instead of looking at stuff through the price, view things in terms of inflation-adjusted dollars. I think this is an interesting point.
Conclusion
Knowing about inflation is good. Being aware of it is even better. One can not go wrong by being more prudent with your financial situation. Having good financial habits will not harm too.
Speaking of investment portfolios, maybe you can diversify your diversified portfolio further by buying ETFs of different types.
The diversification of your portfolio depends on you, your age perhaps, and also what investments you understand personally.
Anyway, that’s all for this article. If you feel that this is useful and can be useful for other people, feel free to share! If I miss anything or if you have anything to add on, feel free to share them in the comment below.
Thanks for reading folks.
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- MooMoo
- Interactive Brokers
- StashAway
- Syfe (Referral code: SRPT38VH3)
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