WORDS ON WEALTH
In light of the problems at Ecsponent (see “ Ecsponent advisers face enforcement action”, Personal Finance, February 29), I thought it necessary to revisit investment risk.
There are two basic forms of investment – shares and interest-bearing instruments – and they have very different risk-return profiles.
1. Shares.
If you buy shares (equity) in a company, you become a part owner of that company and share in its profits in the form of dividends. Although the dividends may remain relatively constant, the share price may swing up and down, based on supply and demand. This up-and-down movement of the share price is called its volatility.
When you invest in shares, your return, which comprises dividends plus any capital gain afforded by a rise in the share price, is never certain. If you choose your investment wisely, you may be relatively confident that, over time, the company will grow and that your return, despite short-term volatility, will reflect that growth.
However, if you choose badly, and the company lands in trouble, it is likely to stop paying dividends and the share price will plummet. This is a risk you assume when you become a shareholder of the company.
2. Interest-bearing instruments.
These are basically loans: you lend money to an institution, and in return the institution pays you interest, typically at a fixed rate, for the use of your money. There is usually a term for the loan, after which your capital (plus interest if it has accumulated) is returned to you.
These instruments can be divided into cash investments issued by banks, such as fixed deposits; and bonds, issued by governments and big corporations. There is no “ownership” in such an investment. If the institution goes into liquidation (if it’s not a government), its creditors get first bite at the asset pie. Its owners (shareholders) get what’s left over, if there is anything left over.
Interest-bearing investments are typically low risk. They usually offer a fixed rate of return, albeit often lower than what you could potentially receive from an equity investment. But there is still risk: it is the risk of the issuer not honouring the terms of the loan. With a government, large corporation or bank, however, you are in pretty safe waters.
Now we get to Ecsponent. This is a small, JSE-listed company that issued preference shares to the public to raise money for its relatively high-risk business endeavours. Preference shares are something of a hybrid between ordinary shares and interest-bearing investments. They offer part-ownership in the company, but have a fixed rate of return (in the form of dividends, not interest). On the face of it, they may appear as low-risk as a bank fixed deposit, whereas in reality, they have the risk profile of an equity investment.
The terms and conditions of Ecsponent’s preference share investments fully spell out the risks. But were investors fully briefed by the financial advisers selling them? Or were the risks glossed over and investors led to believe they were investing in something as safe as a bank deposit?
If you invested and believe the risks were not fully explained to you, I would like to hear from you. Email me at martin.hesse@inl.co.za