It's essential to understand risk. Even though the finance and insurance industries prefer you not to. In this episode I'm joined by Vince Scully, Chief Sherpa at Life Sherpa, to delve into the intricacies of risk management. We explore how risk is perceived differently by financial experts and everyday investors, and why this understanding is crucial for anyone looking to build wealth or protect their assets.
What does risk mean for the average investor.? Vince explains that while many people associate risk with the potential to lose money, it also encompasses the possibility of achieving greater returns. This duality is at the heart of financial decision-making, where the challenge lies in balancing the danger with the opportunity.
We also tackle the concept of diversification, highlighting its importance in reducing the probability of loss. Investing in a basket of stocks, rather than a single stock, can significantly lower the risk of losing money. However, even with diversification, the market's inherent volatility means that some level of risk is always present.
One of the episode's key takeaways is the idea that the ultimate risk might be not taking enough risk. Vince emphasises that while playing it safe might seem appealing, it could lead to missed opportunities for growth. This is particularly relevant in the context of retirement planning, where the need to generate sufficient returns often necessitates taking on more risk than simply depositing cash in the bank.
The conversation also touches on the concept of sovereign risk, using real-world examples to illustrate how geopolitical factors can impact investments. Vince shares insights from his experience in the mining industry, where navigating sovereign risk is a critical part of doing business in less stable regions.
Don't risk not understanding risk.
TRANSCRIPT FOLLOWS AFTER THIS BRIEF MESSAGE
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EPISODE TRANSCRIPT
Vince: You buy a lotto of ticket. You're buying into the dream that your six or nine numbers are the ones that are going to come up. You have a very, very high probability of them not coming up, but the 1 in 10 billion or whatever the probability is is enough to create a fr on of excitement that's worth $8.99 or whatever, uh, a lot of ticket is. So it's about, I think, embracing the risks you want to take and are happy to earn the reward for and making the ones you're not prepared to or can't afford to take go away.
Phil: G'day and Welcome back to Shares for Beginners. I'm Phil Muscatello, and today we're delving into a topic that's at the core of every financial decision, and that's risk. When it comes to building wealth or protecting assets, understanding risk is essential. So I'm joined today by Chief Sherpa at Live Sherpa, Vince Scully. G'day, Vince.
Vince: G'day, Phil. It's great to be here. From not quite so sunny Sydney to, uh. But it looks quite sunny where you are.
Phil: No, no, it's overcast here up in Queensland. Supposedly sunny Queensland.
Vince: Perfect one day heaven the next. Is that what the story is?
Phil: Something like that. Something like that. But, uh, yeah, it is very nice up here and it's been great moving from Sydney to. To the Sunshine Coast, I've got to say. But I do feel like it's a bit of a cliche up here. No, I'm glad now that I've finally got Queensland plates on the car.
Vince: Not Mexican.
Phil: Place less ago. Get less aggro on the road. So, Vince, is it true that you're famous for your Risky Business Tom Cruise impersonation dances?
Vince: Uh, I was about to say you should see me in my whattsox, but that's actually Kevin Bacon, isn't it? Always get those two guys mixed up.
Phil: I think there's white socks and wife fronts involved in both of them, but. Okay, yeah, we'll spare the listeners that dance.
Vince: Yes, yes, Good job. This is radio and they say I've got a good body for radio.
Phil: Okay, so we're going to be talking about risk, and it's about the difference between what the financial services industry thinks risk is compared to what ordinary punters think risk is. So, yeah, let's break that down. What do ordinary paners think risk is in your experience as a financial advisor?
Vince: Yeah, I mean I think most people, if you ask them what does risk mean, they would think the stuff going wrong, stuff going bad. And when you first start thinking about finance or investing, that usually leads people to the oh, I might lose my money. And so I think risk at first blush is the probability that I'll lose my money. And the probability of that happening if you're buying a single stock is actually relatively high. So you know, when you look at the companies that have been listed on the stock exchange, you don't have to think too hard to come up with a list of pretty high profile companies even in Australia where the investors have lost their money. I think Virgin Airlines, Babcock and Brown, mfs, CIT Pacific, ABC Childcare and some less spectacular ones where you've just lost some of it. So I think that's what most people think of. And if you move from single stocks to baskets of stocks, whether it's a LIC like Australian Foundation Investment Company or a traditional managed fund or an ETF where you're buying potentially hundreds or thousands of companies, the probability of you doing your dough completely is becoming vanishingly small. There's certainly uh, a probability that you might lose some. If you say you're going to buy an Australian broad market index like an ASX 200 or an ASX 300 fund, you probably have a 1 in 4 chance of losing money in any one year. And so it doesn't go away, but it becomes much.
Phil: Well it's not actually losing money unless you lock in that.
Vince: Well that's true. And so that's where investment horizon comes in. That one in four years might be negative, but I'm not sure there's been a negative decade. I think there's been a negative five year period, but I don't think there's been a negative decade. You don't have to look too far around the world to find negative decades. Japan 1989 is s a good example. The US 1929
00:05:00
Vince: good example, where uh, you can go long periods but the longer your horizon and the broader your diversification, the lower your chance of losing some money. The odds of you losing it all, I think you would say is vanishingly small. And if you did, you probably have way bigger problems than the fact that you've just lost your investment.
Phil: You've in fact taken on way too much risk, haven't you?
Vince: Well, if you think about Australia, where the ASX 200 goes to zero. What do you think the country might look like?
Phil: Yeah, that's right. I'BE in our survival bunkers.
Vince: That's right.
Phil: Trading ammo, uh, and uh, fishing gear.
Vince: That's right. It starts to look a lot like Mad Max. So I think that's what most people think about, ah, risk at first index. If you look up risk in the dictionary, you'll find synonyms like danger, but you'd also find words like opportunity. And it's the balance of those two that's the key challeng in well, in most financial decisions and investing in particular. And so your ability to predict is pretty low. So if someone says, well, what do I think the market will do tomorrow? Well, the shorter answer is I have no idea. I can tell you that on average it goes up more than it goes down. But I can't tell you whether Tomorrow is A, A plus 1 plus 2 plus 3 or minus 1 minus 2 minus 3 day. And when you think that you can, that's probably the riskiest decision you could make. That rather than trying to predict, you should be asking yourself, well, what would I do if that eventuality happened? You should be thinking about these things and go, well, if the market did fall 5% tomorrow or 30% over the next three weeks, as it did in 1987, what would I do and what impact would it have? And if the impact is something that you can't tolerate or can't recover from, then that's probably a risk you shouldn't be taking. But in order to make a return, you need to take risk. And the level of return you expect will drive the level of risk you need to take.
Phil: And it's different for every person. I mean, if you want a risk free investment, the closest thing we have to a risk free investment is putting less than $250,000 in a term deposit in an Australian bank. But when I was researching this episode and I was looking at various definitions of risk for another person, there's a risk that they're not going to match the ASX 200 or the S&P 500. That kind of investor sees that as a risk as well. How do you balance those two?
Vince: Yeah, and that's a challenge. So you know, everyone in the market is trying to achieve something different. So some people are in the market to make risks like that go away. So if I'm an insurance company or a, a defined benefit pension fund and I've got an obligation to Pay Phil Muscatella $1,000 a month linked to inflation for the next well, however long Phil's going to live, I need to be investing the money that Phil gave me to make as much of that risk go away as possible.
Phil: And the risk that I'm going to hit 90.
Vince: Well, yes, I mean, that's probably the hardest one to hedge. But the risk that inflation turns out to be 30% instead of 3%. So there are things that I can invest in, like inflation in bonds, that might help make some of that risk go away. I can closely hedge it by buying real estate. It's not a perfect hedge. I can look to get a higher return than I've agreed to pay Phil and use equity to cushion the difference. Uh, maybe I could take the opposite risk of selling life insurance, which is betting on someone like Phil dying before I think they're going to buy, which is maybe a way of hedging the fact that Phil's going to live longer than I think he's going to live.
Phil: I've promised, I've given up smoking.
Vince: So not everyone in the market's playing the same game. So an insurance company is likely to want to make those risks go away as much as possible because the more those risks they take, the more equity they need to put in the kitty and therefore the more they have to charge you for your insurance. On the other hand, if I'm an investment bank helping BHP raise another billion dollars, then I probably want to make the risk of the stock market moving before I've underwritten
00:10:00
Vince: the deal that I'm probably comfortable taking BHP risk, but I don't really want to take the market risk. So I might short the stock market, that is sell, either buy protection or sell short so that when the market falls, the value of what I've just bought goes up and therefore I've made my stock market broader risk away and I'm left with BHP risk or the risk that I can't find enough mug punter to buy a billion dollars worth of BHP stock. Energy retailer where I'm agreeing to sell you electricity at a, uh, fixed price for the next three months, I might want to make the risk that the wholesale price changes go away. And I can do that by entering into long term contracts to buy electricity from power stations, or I can buy options or futures. If I'm Qantas, I might want to make the risk of the fuel price go away by forward buying some of my fuel for the next year.
Phil: That's often referred to as hedging, isn't it?
Vince: Yeah. So all of those things are, uh, people doing things to make risks that they're not prepared to take go away. Now all of those come at a cost. And so on a more domestic basis you the choice to take out a fixed rate home loan instead of a variable rate home loan is a way of making the risk that interest rates go up and you can't afford to make your mortgage payment go away. It comes at a cost, it comes at a cost of flexibility. It comes at an opportunity cost that you might miss out on lower rates in the future. But you shouldn't be treating that as a bet against the bank. You should be treating that as a I'm buying certainty at the expense of flexibility and perhaps at their risk of paying more over the next three years and giving up the or making it more expensive to refinance. But that's a risk trade off where I'm looking for certainty and I'm prepared to pay something for that. So risk is really a summary word for uncertainty of outcome. Some uncertainties of outcomes are good. Yeah. So if you buy a lot of ticket, you're buying into the dream that your six or nine numbers are the ones that are going to come up. You have a very, very high probability of them not coming up. But the 1 in 10 billion or whatever the probability is is enough to create a frizz on of excitement that's worth 8 dol 90 nines or whatever a uh, lot of ticket is. So it's about, I think embracing the risks you want to take and are happy turn earn the reward for and making the ones you're not prepared to or can't afford to take go away.
Phil: So that's what insurance is all about, isn't it? That they're taking. You're paying an insurance company to take away the worry of risk. You know, you don't want your home to burn down, for example.
Vince: And's yeah, I mean that's still, that's.
Phil: Really the same thing. I mean risk, uh, risk is one of those terms that seems to be it is this one thing. And um, but the way people view it can be a many faceted thing.
Vince: It can. So with your example of insurance, you know, there is a small but devastating probability that your house will burn down and it's almost impossible to save enough money to be able to afford that impact when it does happen. So there'the times we're spreading that risk across a large population where the average does average out. So if you've got a pool of 10,000 people and one in 10,000 houses burnned down every year. Well, if you each Pay the cost of one house buring down, you've now made that risk manageable for everybody. 9,999 of those people are going to come out of the, the year as losers because they spent Money they otherwise wouldn't have had to pay to make the devastating impact of them being the 1 in 10 thousands. And insurance companies get really good at uh, working at these odds. They have armies of people called actuaries who uh, comb through those statistics and work out, well, what are the indicators of people's houses might be more likely than average houses to burn down. So living in a bushfire zone, um, will obviously make that cost go up. Living in a flood zone will make that cost go up. Not having a smoke detector might make that cost go up. And the skill of a good insurance company is to take all of those things into account so that
00:15:00
Vince: on average everyone gets cheaper insurance. But some people pay more because their risk is high. In some cases that risk is so high that even an insurance company can't take it. So in New Zealand you've got the, the earthquake commission where the government accepts that risk that if there was a massive earthquake in New Zealand, the insurance companies take the first small hit. But the hundreds of billions of dollars it would cost to rebuild the entire country is something that no one can take apart from the government. I think Australia's got a terrorism equivalent. I think terrorism insurance is underwritten by the government in, in Australia. Dust Diseases Board similarly covers things that's hard for commercial risk takers to take it.
Phil: So speaking of two sides of the same coin and the multifaceted view of risk, how does the finance industry define the link and the nexus between volatility and risk? Something going up and down.
Vince: Yeah, that's actually quite a controversial topic in finance, that volatility, which is really a measure of the variability of returns. So we can say that the volatility of the Australian stock exchange is X and it's about 10% which is the standard deviation of returns. Now it's a statistical concept which says that if the average return is 12 ish, then 2/3 of the years the return will be somewhere between 12 minus 10 being 2 and 12 plus 10 being 22. And that's what statisticians call the standard deviation. And it's a useful way of comparing two things. Sorry, if I'm looking at a return, a market that's going to give me on average 12% and has a standard deviation or volatility of 10%, that tells me something about the risk I exposing myself to doesn't necessarily tell me what the impact of that risk might be. But it's a useful mathematical model to compare two risks. So if you compare a 12% expected return with a 10% standard deviation or volatility to a 14% expected return with uh, a 20% volatility, the higher return one will have a wider spread of returns and my expected outcome can vary by more. Now that might be a uh, an acceptable trade off to me for the higher expected return which could be that I've got greater flexibility in my, when I want to achieve my goal. So if I've got a goal that's a year away and ah, let's say my kids going into year seven in a year's time and I've got to write a check for $30,000 to the school, well I probably can't afford to put that $30,000 into the stock market and earn 12% plus or minus whatever it could be. So in Australian's case, you know, the worst year was probably minus 40 and the best year was probably plus 40 or plus 50 with an average of 12. So the minus 40 outcome in that year is probably a risk that I can't to take and therefore I should be putting that $30,000 in the bank, getting the benefit of the government guarantee that you just talked about and having pretty well certainty in my, in fact if I bought a one year term deposit, I know precisely what I'm going to get on the first day of term next year. And so I've made almost all of those risks go away. But if I didn't have 30,000 less a years interest and I needed to get a 10% return in order to be able to pay for Charlotte'school fees next to year, then I have to take some risk because I know if I stick it in the bank I will have 100% chance of not being able to pay for Charlotte'school fees. And that's a risk that I'm probably not prepared to take. I could perhaps make that risk go away. Well, well actually I don't have $30,000. Therefore you've got to go to a cheaper school. Charlotte, I. No, you can't bring your horse with you. But if uh, I.
00:20:00
Vince: Daddy's lost it.
Phil: All on the market.
Vince: That's right. So that's where risk comes to play in practical terms. Now that plus or minus the 10% volatility will decline over time. So the volatility of the 5 year return or the 10 year return is much lower. And that's why we talk about being, if I've got a long term horizon, I can afford to buy riskier assets. By riskier in that context I mean more volatile. And because the odds of you having two of those, uh, five of those minus 40 years turn up in five years is close to zero. And quite often bad years are close to good years in practice. So if you look at two of the best years in the Australian market, we're in the 2008-2011 period or 2007, 2011, as we're two of the best years. So staying out of the market to avoid these short term things is a pretty hard trick to pull off. But I do need to make sure that the risk I'm taking in the context thereof, how uncertain my outcome is going to be, is compatible with the goal I'm trying to achieve. And that's where retirement planning in particular becomes a, an issue that uh, you have three levers you can pull when it comes to achieving these goals. There's how much you set aside, there's how long you've got, and then there's the return you need. And if you pick any two, the third is therefore fixed. And not all of them are feasible. So if you want to pay for your retirement, saving a retirement income with a, uh, very high degree of probability by sticking it in the bank, then you're going to have to save a lot of your lifetime earnings to pull that off. And that's a bridge too far for most people. So most people have to accept that I simply can't save enough of my lifetime income to pay for the retirement income I want or the retirement lifestyle that I want. And the trade off I'm prepared to make is I'm Prepared to save 5, 10, 15, 20%, pick a number of my lifetime income to not spend it during the 40 years I'm working so that I can spend it during the 30 to 40 that I won't be working. And therefore there is a return I need to achieve that. And that will mean I've got to take, accept more risk than sticking it in the bank. And so sometimes the ultimate risk is not taking enough risk. So if being in the stock market is risky, not being in it is even riskier for most people.
Chloe: Super is one of the most important investments you'll ever make. But how do you know if you're in the best fund for your situation? Head to lifeshhererpa.com.au to find out more. Life Sherpa, uh, Australia's most affordable online financial advice.
Phil: So another Kind of risk that has been in the news lately is sovereign risk. And I think there's been no greater example than Resolute Gold in the last week, where senior management is now under arrest in Mali, in Africa. And for a company like this, a gold mining company that operates in Africa, sovereign risk is one of the greatest challenges that they face, isn't it?
Vince: It is. And that's why you would expect to get a higher return for investing in a gold mine in Mali than you would for investing in a gold mine in New South Wales.
Phil: Is that because you're taking on more risk? Is that the case?
Vince: You are. And in this particular case, it's a very personal risk because these guys are in jail. And so we saw that with Crown executives in China, we saw that with, um, BHP executives somewhere else. So they're very personal risks and management usually is very alert and conscious to those things. But the risk that the government renes on the deal or blocks convertibility of the currency or prevents you exporting the, uh, profits or the railway you're using to take the ore to the port gets blown up, they're all variations on sovereign risk. In Australia, we're seeing some of this play out right now in the Sydney toll roads
00:25:00
Vince: where the current New South Wales government is playing the. Well, you, our predecessors 30 years ago didn't really mean you to be able to charge that much of toll. And it's now inconvenient because these tolls have got very expensive and therefore we want to renegotiate the deal. That's sort of a very simple example of sovereign risk. There's the risk of laws changing. And from my personal experience, uh, I worked on the Gold Ridge gold mine in the Solomon Islands in the late 90s. In the 90s anyway.
Phil: And, um, how did you look in a miners's hat and a high visz vest?
Vince: Well, there wasn't actually a mine there when I was there. It was just a piece of dirt, but.
Phil: So you just had a shovel, did you?
Vince: That's right. Yeah. I was trying to shovel money into this pit. But the challenge at the time was that most of the banks around the world weren't lending to the Solomon Islands because the Solomon Islands was considered a bad guy for deforestating. Is that the wed much of the island, it was also notorious for unstable governments. So the real option was that you needed to go and deal with one of the multinationals. So in Australia, there's a company called the Export Finance Corporation who can help with those risks. In this particular case, we got sovereign insurance from the Commonwealth Development Corporation who were willing to take the risk that uh, or insure the loan that we were arranging against change of government, non convertibility of currency, contract renunciation, all those sort of things, terrorism. And we then arranged a gold loan so that the mining company borrowed in gold and of course they had tens of thousands of gold in the ground. So that allowed them to hedge some of the gold price risk and it made a lot of this sovereign risk go away. That company went through a number of takeovers between doing the deal and the mine actually opening and that within weeks of the mine opening the country was overrun by these militia. And so the mine didn't hit production. I think it's in production now, but back then it wasn't. And the uh, Commonwealth Development Corporation paid out the lenders. So that's a good example of sovereign risk in how you can manage it. But it is a real problem. Not, I mean that's an extreme example but you know, uncertainty, uh, about the regulation of clean energies in Australia is a really good example for this. This is putting off overseas investors buying wind farms and solar panels and all those sort of things in Australia because of uncertainty about what the future price and the future regulation of the energy market will look like. That's probably the practical example for a lot of people that the more severe ones about contract renunciation, non convertibility of currency, capital controls, change of government, all of those things are more associated with lesser developed countries. And in Australia you're focused on well, what's the certainty about regulation? Is the government going to change the deal? Am I going to lose my license? Is a future government going to turn around and go, well actually we're going to ban all future nuclear or uh, uranium mining. And so that's a risk an investor focuses on and therefore you should focus on this when you're looking at individual companies. So if you're investing in a lithium mine in Chile, I think that's the main lithium producer these days. You need to be conscious of what the political environment in Chile looks like. I think Chile's relatively stable and that's probably not that big a deal. But you see what happened with Valet or Vale in. Maybe it is valet, given what happened to the um.
Phil: It is valet. Valet, I think.
Vince: Yes. So they had a retaining tailings dam wall fail and inundated huge numbers of people. That's a uh, billions and billions of dollars of compensation which could be terminal for a lot of smaller companies.
Phil: It's really interesting the idea of risk and one of the great books about risk is the Black Swan by Nicholas Taleb. Have you read that one? That's.
Vince: Yes, that. It's a hard read, but a great. Yeah, great.
Phil: And it's about the unpredictability of risk. And he gives a great example of a casino. And you think a casino would be experts at managing risk because that's what they do every day. But for example, they, um, the team, Siegfried and Roy, they were line tamers that had an entertainment act
00:30:00
Phil: in one't.
Vince: Didn't he get eaten by one of the law?
Phil: Eaten? Yeah, yeah. Where they were insured for a lion escaping and mauling one of the members of the audience. But they didn't think to ins. Ensure against the lion mauling either. Sieg Frieda oroyy. I can't remember. And then there was another claim that they had or there was another situation where every month the Nevada Gaming Board had to be given some paperwork and this one employee for about 10 years, instead of sending the paperwork to the gaming Board, they just put it into a drawer. They had no idea about that until the fines came and they got these huge fines. So yeah, it speaks to the unpredictability of predicting the risk that you should be actually even looking out for.
Vince: That's right. And the GFC was a perfectly good example of this. That with subprime mortgages there was a, uh. When you're trying to structure these things, you focus on the probability of default. That is what are the odds of one individual failing to pay their mortgage and then uh, the loss given default, that is, what am I going to lose if this one guy does default and I have to sell his house? And so the general expectation was like if you lost given default was let's say 20 cents in the dollar and you expected 20 out of the 10,000 mortgages to fail. You would be able to say, well, I can fund 90% of this pool with AAA bonds because the uh, probability of chewing through the lower rated ones was so small and therefore I could achieve standard and pous or Fitch'or Moody's test of what's my likelihood of default. So AAA doesn't mean you're never going to lose money, but it means the odds are uh, very small. That was all modelld based on these events, all being independent. That is the odds of Phil defaulting his homeland where independence or whether Vince defaulted on his home loan or not. Those two entirely separate events. But what the model didn't take into account was that these pools of loans were often originated by single or local banks. So, uh, A pool of 10,000 Orange county mortgages is not as riskless as 10,000 spread across the country. So when the Orange county market plummeted and everyone handed their keys back, suddenly those high rated bonds weren't actually worth as much because you chewed through the bottom ones and now you are exposed to the lower end of that risk as well. And that's what led to much because not only was this pool of orange candy loans, but those bonds were then chopped up and put in with other los with some debt. So you had no idea who was holding these things. And so it just created this contagion of fear in the market that no one knew what they had. And so liquidity dried up and so the music stopped and these things couldn't be, no one could move these things. And it took a while to work out what they were actually worth. As it happens, the AAA rated actual bonds, there was close to zero losses on those where we did see big losses and many Australian county councils suffered losses and these things where they were buying parcels of those with a bunch of debt. And so it didn't take too long to chew through the debt in those pieces and that's what led to the ultimate losses. But the Rowl vanilla mortgages didn't actually generate much AA A losses at all, but it was. And I think Tayr talks about this in a second. So that's our black swan or something that we'd never seen before. And the fact that you've never seen it before doesn't mean it can't happen. And the uh, predictability of these events that are way out on either side of the bell curve are really hard to manage. So ye, I sat in meetings at Fitch in 2007 having this argument about how we should look at the potential loss on our loan book. And there was a lot of that will never happen type discussions around that table and we saw the impacts of that sort of thinking. Now it might be uh, our.00001% chance of happening or whatever, how many zeros you want to put before that one. But the consequence of happening could be so severe so that the math starts to break down. Because when you multiply a very, very small
00:35:00
Vince: probability by a very high loss, you end up with a very high low expected loss. But the consequence of happening is massive. And for most individual investors that's a uh, step too far. So you do have to think about these events and they're called black swan events. Interestingly that Europeans thought that all swans were White because they'd never seen a black one. And no matter how many white swans you see, it doesn't tell you any more information about the probability of that being a black one. And then of course the Polms turned up in Perth in 17 whenever it was and saw black swans all over the place. And so now they knew black swans existed. And every additional black swan they saw didn't give them any more information about whether the black swans existed or not, but they now knew they did. And so before then most people would have taken any bet against their being black swans because all swans were white. But now we knew there were black swans. And that's the significance. That these are events that most rational people would go, that is so improbable, it's not going to happen. I don't need to worry about it. But you do need to worry about it. And that's often where insurance can come in handy, that the uh, impact of this risk happening, however unlikely, could be catastrophic. So if you're a couple with young kids in a big mortgage and you depend on two incomes to pay the bills, well, the loss of one of those incomes, either through death or disability or long term illness, could be catastrophic to that family's future. Which, what lifestyle changes can they make enough lifestyle changes to fill the gap? Can they sell enough assets? Or do they end up not paying bills? Ah. Or which goals are they going to abandon? And all of those things often lead you to say, well look, if I'm a couple with kids and I've got a big mortgage and we're a two income household, then you almost certainly need income protection insurance. You may or may not need life insurance if given that death is cheap and most of your costs go away. But you certainly need income protection insurance and that's really the concept. Car insurance is the same. You might say, well look, my car is worth 10,000 dol, I've got a 10 grand emergency stat. My car gets stolen or written off, sure I'm going to feel the pain, but it's a catastroph that I can manage. But the uh, cost of driving into someone else's Bentley or running someone over in the street would be catastrophic. And that's what the government makes us have, third party insurance.
Phil: So let's move on to credit risk. Now this is where we're going into what's often considered to be the safer end of investing, like with infrastructure, government bonds, corporate bonds. But tell us about credit risk and how this can affect the safety of these kind of investments.
Vince: Yeah, That's a uh, good point. So when we think about bonds or fixed interest, so even a fixed interest can sometimes be variable. We talk about you income creating instruments. So usually these are loans to historically governments or companies and in more recent cases financing vehicles. So when you take out a home loan, especially with a non bank that's packaged up and sold off into what are called RMB residential mortgage backed securities and there's a commercial property equivalent called a CMB as a commercial mortgage backed security and they all have various different credit characteristics. We generally think about credit in. There are three things that drive returns on credit instruments. First of all is that credit quality of the issuer. So that is what is this probability that this issuer is not going to be able to pay me in full and on time? And when you're dealing with Australian dollar bonds issued by the Australian federal government, the answer question is vanishing small or close to zero. That the uh, Australian government can always print more Australian dollars or raise taxes. That it's almost impossible for the Australian government to default on an Australian dollar obligation as you move in you'd say well Victoria's a bit more risky than the federal government. Queensland might be a bit riskier than New South Wales for example. I not quite up to my relativities at the moment. But you'd certainly be able to rank the states in the likelihood of them repaying. You then
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Vince: get uh, a little more risky things like the NBN company which is sort of government but not quite so as you step down the uh, quality, you increase the probability that you might not get all of your money back and therefore you expect to be rewarded more highly for them. So buying Greek government bonds you would expect to be paid more than buying Australian government bonds. You then look at the term. So as a general rule you would expect to be paid more for a 10 year bond than a 90 day or one year bond because there's longer for these bad things to happen and there's more uncertainty in the future. So tenor is another driver of returns and then the final one is currency. So you've got two governments, both of whom are AAA rated, which is the highest rating that the agencies will give you. One's issuing in Australian dollars, one's issu in Euro. You might for example accept a lower return on the Euro bond because it's got 350 million Europeans backing in a whole bunch of rules through the European Central Bank. But a uh, Euro bond issued by the Greek or Italian government might not have Quite the same_ard so you take those three together and that increasing return for longer term is a normal yield curve. So that is the yield curve measures, is a marker of return for each term and generally it slopes upwards. So two year bond.
Phil: So um, sorry, let's just go over the yield curve briefly again because it's always a confusing concept but it's government bonds have duration, they can be 12 year, all the way up to 10 year, maybe even 30 year bonds. And in a perfect world the yield curve goes up. The longer that's you're going to be lending money to someone, the more you're going to be expecting to be paid.
Vince: Because re.
Phil: It's inverted at the moment though I think is.
Vince: It is, yeah. So the yield curve is really a graph of the return you would get if you buy that term of bond from that issuer at various lengths. And generally you would expect that it will slope up to the right that 10 years is, should give you a higher return than a five year bond.
Phil: Yeah, that's like if um, if I was to lend you some money and you said to me look I can pay it back to you next week, you know, I need a hundred bucks, I'll give you 102 bucks next week. That's you. It sort sounds like a reasonable deal but if you say I'll pay you back that 100 bucks in 10 years time, I'm going toa want a little bit more money for.
Vince: That's right. So both because it's a longer period, therefore you've got more periods of 5% to pay but you've also got the fact that Phil's going to be much riskier over five years than years over 90 days. So I want a higher yield on that. And if you plot that out over time, you generally get an upward sloping curve because it measures both market expectations are where normal interest rates are going to go. So if the market is expecting interest rates to fall over time, you can often find that short term interest rates are higher than 5 or 10 year. So today I think the Australian government 5 year bond is trading below the RBA cash rate. And so you have this dip in the early part of the curve. And so you actually don't get rewarded for your five years risk today. And that's because the market expects that interest rates going to fall in the future. And therefore uh, an inverted yield curve is often a leading indicator of inflation or recession because the expectation is that if there was a, if we run into tough economic times, the government's likely to lower the interest Rate to stimulate the economy. So a deeply inverted yield curve that is a slopes downwards for at least downwards to the right for at least some of its term is often indicated that turbulent times ahead or I think what we're seeing today is the expectation that the need to hold rates up will be short lived. So telling the difference between those two is more of an art than a science. So when I'm trading, if I want to buy a bond fund or I want to buy some fixed interest in my portfolio, the return I'm going to generate is a combination of those three factors,
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Vince: issuer, credit, term and currency. And so when I'm putting together a bond portfolio I can choose whichever one of those I need or whatever combination of those I need to give me the return and risk that I'm prepared to take. And at small levels in our uh, portfolio. So if you're looking at going from 100 0, 100% growth to ah, a 90% growth to an 80% growth, you're really looking for very high grade bonds to give you that volatility damping. And because it's in such a small quantity it doesn't have a huge impact on your overall return. But if you're going to move down to a 70, 30 or a 60, 40, you now need to generate some return from that 30 or 40 that's ineensive. And so now you might actually move up the risk curve. So quite often in a 6040 portfolio you might have had some big bang hybrids for example, which are debt and so generate fixed returns but have some equity characteristics. They may not be available for very much longer but that's where you would look at that. And this is where buying an index bond fund becomes hard. Because if you go and buy standard, A Vanguard, Australian fixed interest funds, VAFF or the uh, BlackRock equivalent IAF, they both have quite long durations, I think it's about five to seven years. Which means you are by definition of buying that index going long duration. So you are uh, taking or buying a portfolio that will be reasonably sensitive to changing interest rates and that may or may not be consistent with the uh, rationale for buying bonds in the first place of lowering volatility. And so this is an area where active management can generally add value in two ways. One by increasing the return you can expect for a given level of risk and secondly by playing the rating duration currency game you can achieve the volatility dampening you need and whatever return objective or a yield objective. So all of those things are trade offs and that's why indexed bond funds can be problematic more because of the structure of the index than, um, of the concept of having pooled bond funds. And because bonds come in such big chunks, it's actually quite hard to buy them with a meaningful spread individually. So most people will end up with a, uh, diversified bond portfolio and the analysis is harder to do.
Phil: So Vice all this discussion of risk makes me want to go into the bedroom and curl up into the fetetal position, but resist that urge. But it's been great chatting with you again today. So Vince Scully from Life Sherpa, thank you very much for joining me today.
Vince: Well, thank you Phil. It's been a blast as usual. Thank you.
Chloe: Thanks for listening to Shares for Beginners. You can find more@chesforbeginners.comt. if you enjoy listening, please take a moment to rate or review in your podcast player or tell a friend who might want to learn more about investing for their future.
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