What are Low-Risk Investments?
Low Risk Investments are investments that are inherently safer than their counterparts. Stocks are low risk compared to optionsOptionsOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date., bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually. are low risk compared to stocks and treasury bonds are low risk compared to corporate bonds.
However, to define what low risk is, we need to know what risk is and how to quantify it. So let us first look at the ways to define risk, see how to quantify it, and then get into looking at some low-risk investments.
There are numerous ways to define what risk is. To put it simply, – Risk is something unwanted happening. In finance, it might be the moment of the price of an asset in the opposite direction to what the investor has bet.
How to Verify a Low Risk Investment Portfolio?
Quantification of risk is a question of defining the goal of the investment and then the types of risk it has. Let us take an investor who is investing in stocks; the number of risks he has are simple market risks, economic riskEconomic RiskEconomic Risk is the risk exposure of an investment made domestically or abroad. These risks could be macroeconomic factors like government policies or collapse of the current government and major swing in the exchange rates., company default risk, etc. There are measurement methods for each type of risk. The most common way to define and quantify risk is to use it as a proxy for measuring risk. Variance is the most common way to describe what risk is. Combining all the risks gives us what the total risk of an investment is. In a portfolio, add all the risks and see if they are inside the risk profile of investors – in this case, low-risk investments.
Let us take a look at the example to see how it can be handled by looking at a couple of examples.
Examples of Low-Risk Investment
Example #1 – Portfolio
To look at the different types of investments, investors make, let us look at portfolios of two funds. Both of these funds are from AQR capital, one of the world’s leading fund managers, founded by Cliff Asness in 1998. Currently, they allocate and diversify their funds by Alternative InvestmentsAlternative InvestmentsA financial asset that is different from the conventional investment categories such as stocks and cash is referred to as an alternative investment. Private equity, hedge funds, venture capital, real estate/commodities, and tangibles such as wine/art/stamps are all examples of alternative investments. (for high risk takersRisk TakersRisk takers are investors seeking opportunities in the market volatility and risk a great deal in expectation of a high rate of return. Thus, they tend towards high-risk investments with a great potential for returns or a loss at the same time.), Global Allocation (for Medium Risk-takers), Equity Funds (for Medium risk-takers), and Fixed IncomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments. funds (for low risk-takers). If we breakdown the portfolio of each of these funds to a reasonable level, we can see which of them are risky investments and which of them are not very risky investments.
Everything being said, one has to keep in mind that there is no risk without return. Economics says that markets are efficient, and there is no way someone can get a profit on their investments without risks. In case there is a mismatch between the value and price of an asset, it is called arbitrage, and companies are quick to pounce on it and neutralize the arbitrage. As a matter of fact, AQR capital has a fund that is dedicated to arbitrages.
AQR Small Cap:
|Fund Name||Month||1 Year||3 Year||5 Year||From Start|
|Small Cap Momentum||6.64%||-4.05%||11.38%||6.36%||13.74%|
If we look at their reporting, we can immediately see that both the small-cap funds have performed badly for the last year. If I were an investor that had invested in these funds a year ago, I am now worse off than with what I have started. However, the 3-year returns are better.
That means the fund has been successful over the first 2 years and lost lots of money in the last year. Each of these funds has an entire set of history that can be studied. This fund invests in small-cap – companies that are not traditionally big and that are still in the growth phase.
This makes companies inherently risky and difficult for investing. Hence either great or pitiful returns. Since the type of fund indicates what the different assets in which AQR has invested are, the company does not go deep enough to describe all the companies invested. This is because of two reasons.
- They are confidential
- Someone else might copy the strategies.
Fixed Income fund:Fixed Income Fund:Fixed Income Funds are those mutual funds that invest in high quality fixed income securities like the government debt, treasury bill, money market and pay the investors a fixed rate of return as per the payment terms and period. Seeks total return, consisting of capital appreciation and income.
|Fund Name||Month||1 Year||From Start|
|Core Bond Fund||1.16%||6.8%||5.8%|
|US Aggregate Unhedged||1.26%||6.1%||6.48%|
If we look at their reporting, we can immediately see that both the bond invested funds have performed constantly for the last year and over from the start. If I were an investor that had invested in these funds a year ago, I am now reasonably off than with what I have started.
That means the fund has been successful over the last year. Each of these funds has an entire set of history that can be studied. These funds invest in government bonds, especially like treasury bonds, etc. This makes the fund less risky than the first fund we have seen and easy to invest i.
Hence, the returns that lie around the mean, but not across the extremes. Since the type of fund indicates what the different assets in which AQR has invested are, the company does not go deep enough to describe all the bonds in which it invested.
However, the company goes on to say where the invested money is. They say that they hold 11% of the total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equity like cash and the remaining in bonds. They also use the following excerpt to describe how they invest.
“The process begins by identifying the benchmark universe and then adding out-of-benchmark sectors (e.g., global government bonds). This increases the breadth of securities used for valuation. Within the Government and Government-Related sector of the benchmark, this fund seeks to add value through both Country Selection and Maturity Selection.
Once the fund identifies its model portfolio, it optimizes to take into account the scores for each of the securities, fund constraints (e.g., max issuer and country weights), and expected transaction costs.”
The ability to invest is a matter of choice. The investor might choose risky or riskless assets. Low-risk investments are the type of investments, which have low risk – that is low relevance to market and low variance. This, in general, is government bonds of developed countries like the USA, Germany, or Japan. Low risk investments are considered to be safer than generic high-risk investments. However, which is low risk and which isn’t an objectively fixed value, but subjected to the mind of the investor.
This has been a guide to what are Low Risk Investments. Here we discuss examples of low risk investment along with explanation and calculations. You can learn more about accounting from the following articles –