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Oran Hall Anatomy of a low-risk portfolio

A low-risk investment portfolio does not have to be just a collection of fixed- income securities. It has room for other types of instruments that can contribute meaningful growth to the portfolio and offer some protection against inflation.

Among the types of investment instruments that can be included in a low-risk portfolio are Treasury bills, government bonds, corporate bonds, preference shares, money market unit trusts, money market mutual funds, index funds, and ordinary shares.

The value of a low-risk portfolio rests in its lower level of volatility, which offers a higher level of protection of capital. The downside to this is the usually lower level of return, which is derived from lower-risk instruments, but the safety of an investment generally gives the investor greater peace of mind.

Treasury bills are government short-term debt instruments issued by the central bank. Maturities tend to range from 30 to 365 days. They are issued at a discount and mature at face value so that the investor earns the difference between the cost and the maturity value as income.

The central bank also issues other types of short-term instruments, for example, certificates of deposit and repurchase agreements.

Governments, like corporations, also issue interest-bearing instruments with medium to long maturities. They may pay interest at a fixed rate or a variable rate, by which the interest is calculated as the yield of an underlying interest-earning instrument plus a stated number of percentage points.

A major difference between the two is that the price of variable rate instruments generally remains quite stable whereas the price of fixed-income instruments tends to move opposite to changes in the movement of interest rates. Thus, when interest rates increase, their price tends to decline and vice versa.

Nonetheless, bonds mature at their face value, so the investor who holds the instruments to that time does not experience a capital loss except in those cases in which they were bought at a price above face value. The downside is that the funds at maturity are not able to buy the same basket of goods and services as the sum invested.

Generally, government instruments are considered to be safer and thus lower risk than corporate issues. Although there is usually a market for both, they are not generally as liquid as money market instruments.

The best corporate bonds to invest in are those issued by established companies with strong financials and a good track record for meeting their financial obligations. These are more likely to pay interest when due and less likely to default on principal payments.

Preference shares present another opportunity for the low-risk investor. They tend to hold their value, but their price tends to fluctuate inversely with movements in interest rates, just as bonds. Interest on bonds ranks above dividends on preference shares, which rank above dividends on ordinary shares.

Although they have tended to provide long-term capital for companies, the current trend is for preference shares to have shorter maturities – five to 10 years. Those that are listed on the stock exchange offer some liquidity to the investor.

Money market mutual funds and money market unit trusts have a place in a low-risk portfolio. They comprise short-term debt instruments issued by governments and corporations, and the price volatility, or risk, of these funds is low.

The performance of each fund rests on the performance of the instruments, and the price of the shares or units in the mutual fund and the unit trust, respectively, increases as the income that is earned is reinvested in the fund. Generally, no income is distributed to investors, but the investment is quite liquid as the issuer buys back the shares or units readily.

Surprise! Ordinary shares can have a place in a low-risk portfolio although the risk of capital loss is real. They offer scope for a limited hedge against inflation. It is best to select stocks that pay good dividends consistently as they tend to hold their value reasonably well and to select the shares of strong companies with good earnings records in strong sectors of the economy.

One form of equity investing that may be considered is index funds, which replicate a stock market index or a part of an index, such as the sector funds listed on the Jamaica Stock Exchange. The investor buys into a pool of companies in a sector of the economy in the case of the sector funds. Although this approach offers diversification, it is limited as it excludes other sectors of the economy and thus is more risky than a group of equities that is more broad-based.

A better alternative would be an equity fund of a mutual fund or unit trust, which is more diversified. The equity portion of a low-risk portfolio, whatever form it takes, should be relatively small, perhaps no more than 20 per cent.

The low-risk investor does not have to embrace the lowest yields in the market because of the aversion to risk. There are relatively safe options available to build a valuable and balanced portfolio that does not expose the investor to serious risk.

Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.

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