Tue | Jan 16, 2018

Oran Hall | A tutorial on investment options, including the risky ones

Published:Sunday | December 10, 2017 | 12:00 AM

QUESTION:

Please, I would like to know about all the investment instruments, including the risky ones.

Lorna

FINANCIAL ADVISER:

There are many investment instruments and they keep growing and get more sophisticated as time progresses. Nonetheless, I will discuss some of the more common ones available in the Jamaican market.

Risky investment instruments are those that tend to give a return that varies from the expected return, which means they could give a lower return than expected or no return at all, including a loss. There are many different kinds of risk and each instrument is affected some way or the other by one of these risks.

Some instruments are low risk and thus give a more certain return, but others are high risk because they do not promise a sure return. The lower-risk instruments give a relatively lower rate of return, but higher-risk instruments give a higher rate of return.

On the other hand, lower-risk instruments tend to generate lower rates of loss but higher-risk instruments tend to generate higher levels of loss.

Loss and gain refer to change in the value of the instrument, so lower-risk instruments tend to incur little or no loss of capital, although higher-risk instruments may see a loss partially or fully in the value of the principal sum invested. An increase in the value of the sum invested is known as a capital gain.

Low-risk instruments are generally interest-bearing. The least risky of them are short-term and liquid, in that it is quite easy to convert them to cash. Generally, instruments issued by the Government are regarded as being of lower risk than similar ones issued by companies.

Among the low-risk instruments are treasury bills and certificates of deposit issued by the Bank of Jamaica, repurchase agreements, and commercial paper issued by companies.

Treasury bills are debt instruments usually issued with maturities of 30 days, 90 days, 180 days, or 360 days. They do not pay interest as other instruments do but are issued at a discount and mature at par or at 100 per cent of face value. The difference between their value at maturity and what they cost is income.

Certificates of deposit issued by the Bank of Jamaica differ from those issued by financial institutions in that they are tradable whereas those issued by the financial institutions are not.

Repurchase agreements are contracts by which securities are sold with a commitment to repurchase them at the same price at an agreed date plus interest at a stipulated rate of interest. Their maturities range from 30 to 360 days.

Commercial papers are short-term unsecured promissory notes issued by well-established companies at par with interest and principal being payable at maturity.

Bonds refer to longer term interest-bearing instruments issued by governments and companies. The issuer, or borrower, commits to pay interest to the lender at a fixed or variable rate at set times and to repay the principal sum borrowed at the stated maturity date. But there are cases in which there is provision for the principal to be repaid in tranches.

The bonds issued by companies - corporate bonds - are secured by clearly identified assets of the borrower but government borrowings are not so secured. They are called 'bonds' nonetheless, but debt instruments issued by companies without being secured by assets of the borrower but backed by the good name of the issuer are called debentures.

Jamaican residents are able to buy interest-bearing securities issued in Jamaica and in other countries. All government-issued instruments are not regarded as being of the same quality. The debt instruments issued by some governments are sometimes given low ratings by international rating agencies.

The unit trust provides another form of investment in the Jamaican market. It is an investment trust which sells units to the public and invests the proceeds in a wide range of investment instruments for the benefit of the unit holders. Unit prices are not market-determined but are based on the net value of the assets of the investment funds. There are many different types of funds and, because of the wide variations in their composition, the risk associated with them also varies widely.

Some unit trust funds invest primarily in equities, some in short-term interest-bearing securities, some in bonds, others in ordinary stock or real estate or in any combination of the various types of investment instruments.

Their level of risk is a function of the instruments in which they invest, but they tend to be quite diversified, which helps to reduce risk. Some diversify by investing in several types of securities or by investing in securities in several markets, or by maturity or issuer in the case of interest-bearing securities.

Ordinary stock represents ownership in a company. The owners, or shareholders, benefit from the dividends they earn, if they are declared by the directors, and the capital appreciation derived when stock prices increase on the stock market, but stock prices also decline. Nonetheless, they tend to increase meaningfully over the long-term.

Risk is an integral part of investing and investors seek returns that compensate them for the risk they take.

- Oran A. Hall, principal author of 'The Handbook of Personal Financial Planning', offers personal financial planning advice and counsel. finviser.jm@gmail.com