Risk is a significant factor in investment and as a result should not be ignored
In the last two years, Ghana’s financial industry has undergone major regulatory reforms to address the sector’s poor governance, liquidity and insolvency deficiencies.
The increase in minimum capital requirement for existing banks and new entrants by more than 200% to GHS 400 million was major amongst them. The new requirement reduced the number of players within the banking sector from 34 to 23 commercial banks.
The investment sector recently also had its fair share of sector reforms. Key amongst them, was the revocation of licenses of several fund management houses and the placement of a 6-month moratorium on the issue of new Fund Management Licenses, effected on 1 October 2019.
Another directive, yet to be implemented, is the directive issued by the Securities Exchange Commission (SEC), to fund managers, stating the decision to increase the minimum capital requirement of fund managers from the current GHS 100,000 to GHS 2 million by December 2020.
The motive for these structural adjustments and regulatory upgrades is to restore confidence in Ghana’s financial sector and to ensure continuous efficiency in the industry.
The two-year restructuring of the investment sector commenced with the revocation of the licenses of 386 Special Deposit-Taking Institutions (SDIs) and Non-Bank Financial Institutions (NBFIs).
In November 2019, the Securities and Exchange Commission (SEC) revoked the licenses of 53 fund managers. According to SEC, the revocation of the licenses of the said fund managers was a necessary action taken, due to the failure to return client funds and eventually, the folding up of certain finance houses with no public notice.
Industry regulators concluded that the continuous existence of defunct finance houses posed severe risks to the stability of the capital market and the interests of investors.
Ghanaians investors are gradually losing confidence in the finance system and the interest to invest. One major dilemma, they face however when they do decide to invest is simply making a rational investment decision – the choice of what to invest in, how to invest and where to invest.
This article is put together to share some insights into the important factors that investors need to consider before making an investment decision.
Risk
Understanding the risk-return trade-off of an investment is by far the most important principle investors must concern themselves with before making an investment decision. The principle simply connotes that investors are likely to make higher returns when they assume more risk but lesser returns when they assume less risk.
Risk is a significant factor in investment and as a result should not be ignored. It is inherent in every investment vehicle, even in government bonds that are known to be risk-free.
Government bonds are considered free from default risk because they are fully backed government securities; however, there are risk components associated with inflation and interest rates. In an inflationary economy, the rise in the level of inflation could exceed the expected return on Treasury bills.
In addition, when interest rates rise, Treasury bill rates become less attractive, hence a less attractive investment.
According to India Economic Times, “Investment risk is the probability or likelihood of occurrence of loss relative to the expected return on any particular investment.”
In simple terms, risk is a measure of the level of uncertainty of achieving the returns as per the expectations of an investor. Every investor has an expectation. The probability of achieving or failing to achieve, exceeding or falling short of that expectation is defined as risk.
Most often than not, investors desire to achieve highest returns possible while assuming the less risk.
However, return and risk have a direct relationship.
According to the risk-return trade-off principle, the level of risk an investor is willing and able to assume determines the level of potential return the investor should expect. It is therefore important to understand the risk appetite of and as an investor.
An investor is better informed, firstly, of the kind of vehicle to invest in and the level of return to expect.
The Risk-Return Trade-off
The risk-reward trade-off principle associates the assumption of high risks to the likelihood of making high returns on an investment. An investment that promises high returns will likely require the assumption of high risks.
Therefore, if an investment promises 10 percent monthly returns, it is important to understand the level of risk inherent in that investment and how much of this risk you can assume as an investor. This is a vital step when making an investment decision. Understanding your risk profile as an investor is as critical as your knowledge of risk inherent in an investment.
Understanding the risk profile of an investor
In understanding your risk profile as an investor, two factors come into play – your willingness to assume that amount of risk and your ability to assume same. These are two different parameters.
An investor’s willingness to assume a certain level of risk does not determine her ability to assume that said level of risk. An investor’s risk ability is measured by an analysis of the investor’s assets and liabilities whiles his willingness to assume risk is depicted by his level of risk tolerance.
An investor’s ability to assume risk is mainly based on his expected income, net worth and investment time horizon. Assume a 30-year old worker with net worth of GHS 100,000, monthly salary of GHS 5,000 and 30 years left to retirement.
This investor has a higher ability to shoulder more risk than a 55-year old worker earning a monthly salary of GHS 2,000 with 5 years left to retire and net worth of GHS 50,000. This is because the former has more capacity to accommodate investment losses than the latter.
Risk tolerance depicts an investor’s willingness to assume high risk while risk aversion depicts an investor’s reluctance to assume same. The amount of risks different workers aged 30 and 55, with similar characteristics can assume are different. Young investors are deemed able to assume more risk than older investors are.
For heavy investment losses sustained, the 30-year old investor has a longer investment horizon (30 years left to retirement) to recover those losses. However, 55-year old investor, with 5 years left to retirement, might not be able to recover from huge investment losses.
Young investors are therefore capable of investing in securities with moderate to high risk and are often advised to invest in medium to long-term investment vehicles; these have a greater amount of risk compared to short-term investments. Long-term investments generally have higher risk and therefore have potential to earn higher returns than short-term securities.
An investor’s ability to assume risk is easily quantifiable, however, his willingness is difficult to ascertain since the latter is not quantifiable and to do more with psychological factors.
An investor’s willingness to assume risk is determined by several factors, the most important being the investor’s personality type. Investors, based on their personality traits, may be risk accommodating or resistive. In the investment industry, a common medium through which an investor’s willingness to assume risk is assessed is through questionnaires.
In order to gauge the level of risk investors are willing to assume, they are made to answer a set of questions. An analysis of the investor’s responses to these questions depicts the investor’s level of risk tolerance. While one investor is not perturbed by a 10% loss on his investment, another may withdraw invested funds after a 2% loss on her investment.
Being able to assess the ability and willingness of an individual to assume risk has a huge bearing on the kind of investments to consider for or as a potential investor.
Investment Objective and Constraints
Objective and constraints for investing, as an investor are also important factors to consider when making an investment decision. Before making an investment decision, there should be a motive for investing.
An investor’s objective can also be deduced from the responses to a questionnaire. Investors’ objectives typically revolve around safety and preservation of investment funds, capital growth and income generation.
These objectives can however, be affected by the investor’s liquidity needs, tax concerns, investment time horizon, to mention but a few – investment constraints.
Investment Objectives
Safety and preservation of investment funds
A major reason why people invest is to keep their funds safe while preserving them from the loss off value (due to time value of money). Fixed income securities – government and corporate bonds – are known to be the closest to the safest of investment vehicles. Funds invested in such securities receive a specific rate of return in the form of interest with almost no reduction in the initial principal.
Income generation
Just as investors are concerned about the safety of their funds, they are also interested in generating income. Fixed income securities offer the lowest form of income amongst investment vehicles while equity securities offer higher returns. Income from the former accrue in the form of interests while that of the latter are in the form of capital gains and dividends.
To generate more income, investors need to sacrifice the safety of invested funds, and this is characterised by risk. Thus, the riskier an investment, the higher the likelihood to generate more income.
Capital growth
Capital growth is mostly associated with equity instruments. An investor’s return on an equity investment are in the form of dividends and capital gains. Capital growth is measured by the capital gains an investor makes on his investment.
Capital gains are made from the sale of equity securities when an investor sells a security she owns at a higher value than she purchased it. Capital gains are one type of return that accrues to an equity investor.
The other are dividends, which are essentially the same as interests paid on a fixed income security.
However, the payment of periodic interest is contractually binding on the company while payment of dividend is at the discretion of the company. The decision to opt for safety or growth of capital has a huge bearing on risk, hence, an investor’s risk appetite.
Investment Constraints
Liquidity
An investor’s liquidity needs is important in determining the suitable investment vehicle. Debt securities are normally the preferred form of investment for investors who are likely to make withdrawals or investing towards a particular obligation.
In such instances, the term of the security recommended is chosen to match the investment time horizon. Funds are therefore available to the investor when the need arises. Resulting in minimal losses incurred on the investment.
Tax Concerns
An investor must understand the different types of taxes various investment vehicles are exposed to. This enables the investor to decide on the kind of financial instruments to invest in.
In accordance with the Income Tax Act, 2015 (Act 896), resident Ghanaians who are citizens, are subject to tax on investment income and capital gains on all investments irrespective of the jurisdiction.
To put it simply, any investment income and capital gains earned by a Ghanaian, either from an investment vehicle in Ghana or from abroad is subject to tax. A tax of 8 percent is withheld on dividend or interest earned by the investor.
Again, any gains realised from the sale of shares is subject to tax at the PAYE graduated tax rates. The investor could also elect for the gains to be taxed at 15 percent instead.
Interest paid to individuals by a resident financial institution, as well as interest earned on bonds issued by the Government of Ghana, are however exempt from tax.
Interest or dividend on an investment paid or credited to a holder or member of an approved unit trust scheme or mutual fund is also exempt from tax. Hence, any returns earned by an individual investor in a mutual fund in Ghana is not subject to tax and so is income from an approved real estate investment trust.
Investment Time Horizon
The time horizon of an investment is the duration between when the investor commences the investment and when the investment is expected to be liquidated.
Determining an investor’s time horizon is essential for recommending the type of investment vehicle suitable for the investor. An investor with a longer time horizon and less liquidity needs has a higher ability to assume risk. Such an investor should be able to invest in less liquid and risky assets.
In the light of the above, assume an investor who would require funds for the payment of his rent in three months’ time. The suitable investment for such an investor is a debt instrument – a 91-day Treasury bill will be an ideal investment.
The investment matures in three months, just in time for the investor to meet his liquidity needs and the possibility of sustaining investment losses is virtually non-existent. In the same vein, if the objective of an investor is to set up an educational fund for his wards’ university education, a balanced portfolio with greater equity portions is ideal.
Mutual Funds
Equity instruments, compared to other investment vehicles, generate higher returns and are therefore riskier. Equity instruments have consistently produced higher average returns.
It is advisable that the investors have a long-term investment time horizon in order to recover from losses that could potentially occur in an equity investment in the short term. For investors with short-term investment horizons, who want to invest in equity, mutual funds are an ideal option.
Mutual fund is an investment fund where the fund manager pools funds from both individual and institutional investors, and invests them in various securities. The type of investments they make is determined by the investment mandate and focus of the mutual fund.
It is therefore an ideal option for investors with short-term horizon because liquidity of the assets in a mutual fund is more manageable. Losses sustained, are also not borne by one investor but all investors invested in the fund and based on the proportion of funds invested. Doobia.com is a useful source for more information and insight on mutual funds in Ghana.
Every investor hopes to achieve all his objectives when making an investment. However, many are oblivious of the risk-return trade-off and investment constraints to investing. The next you make an investment decision, ensure you consider all the factors involved.
