011：Four Key Issues for Investors

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Today, we're going to discuss four key issuesfor investors: risk, return, liquidity and taxes. And we'll explain those ideasas we go along. And to be specific, every kind of investment has four maincharacteristics: risk, expected return, liquidity and taxes. The purpose ofthis lecture is to explain these four issues.

First, let’s start by talking about risk. Oneway to think about risk is by referring to the probability, or the chance thatsomething happens. For example, let's compare two different investments. Thefirst investment has a guaranteed one hundred percent chance that you will geta five percent return at the end of a year.

The other investment has a fifty percentchance that it will gain five percent over the next year. But it also has atwenty five percent chance that it will do badly and lose five percent and atwenty five percent chance it will do very well and gained fifteen percent.Now, in this second example, the numbers are picked. So the five percent gainis right in the middle. There is a downside risk of negative five percent andan upside gain of fifteen percent. But those are an equal distance from thatmiddle return of five percent. And they also have an equal chance of happening.

So the idea of this example is that, onaverage, the return in this second example will still be five percent. Forexample, if you could find a hundred different investments, like this secondexample, and try them one after another, sometimes they'd be high; sometimesthey be low; sometimes they'd be in the middle. But on average, it would comeout at that five percent level. So here's the question for you to consider.Which of these two investments do you prefer the one with the guaranteed onehundred percent chance of a five percent return, or the one that on averagewill be five percent, but could be higher or could be lower.

Now, the answer to that question will depend on how you feel aboutrisk. If you are risk averse, a term economists use, that means you would liketo avoid risk where you can. So if you have a guarantee of five percent andanother choice, which will be five percent on average, but could be higher orlower, if you're risk averse, you would avoid that risk. And you say, I’ll takethe sure thing. I don't see any reason to take something that involves risk anddoesn't give me a higher expected return.

However, there are other possibilities. Then the opposite of riskaverse would be what? If you are risk loving. A risk loving person will seekout risk where they can. So that person would like the second possibility,which on average will be five percent, but could be higher or lower.

And in between risk averse and risk loving is the category calledrisk neutral. And risk neutral people just don't care about risk. They don'tavoid it. They don't love it. So for that person, these two choices, fivepercent for sure, or five percent on average. If you don't care about the risk,they look just the same to you, and they would be equally attractive to you.

Now, risk refers to how spread out the possible outcomes are. If Ihave a return, that's a guaranteed amount, there's no risk. It's not spread outat all. But if the return could be higher or lower than risk emerges, and thewider the spread between the upside and the downside, the greater theprobability of these high or low outcomes, the greater the risk will be. Now,when thinking about real world financial choices, of course, those are morecomplex, but the same basic ideas apply.

You can think about an investment as having chances of differentkinds of outcomes and putting probabilities on those different kinds ofoutcomes. And you think about how high is the upside, how low is the downside?And on average, what's likely to happen? Risk isn't a good thing all by itselfunless you're really a risk loving person. Most people would avoid taking riskjust for no reason at all. Usually, if you take more risk, you expect to getsome additional return. For example, if you start your own company, you don't doit just because you love risk. Usually you do it because you're hoping for abig return. A common way to reduce risk is to diversify.

There's a saying in English, I’m not sure if it's used in China. Thesaying is “do not put all your eggs in one basket”. The danger is if you carryall your eggs in one basket and something happens to that basket, all your eggsget broken. In financial terms, this moral means don't put all your money inone risky investment, because if something happens, that one investment, youcould be wiped out.

If you buy a bunch of different kinds of investments, stocks indifferent companies， bonds indifferent companies, some of them will do well，some of them will do poorly. But it's unlikely they will all do wellor poorly at the same time. So some of those good and bad outcomes will tend tobalance out. In that sense, you can avoid some of the extreme risks that arelikely to happen. Another way of reducing risk is to think about how long youare holding an investment in a short time, say, a stock price could jump up ordown. But over a longer time, those short term jumps tend to balance out. Andinstead, what you get is the long term average.

Let's now shift to our second category, expected return. Now, thisidea of the return, what percent gain you get over a year has come up a fewtimes already. When I refer to an expected return, what I'm really saying isthe return you expect to get on average, given the probabilities of high andlow outcomes. And the key point to realize here is that there is a tradeoffbetween risk and return.

It tends to be true that if something is very safe and has very lowrisk, it will usually have a lower return. The greater the risk, or the chancethat it will have a higher risk, means that the return will be higher onaverage, but it could also be a lot lower. So for example, a bank account is very,very safe and low risk. Like most countries around the world, China'sgovernment has a system of insurance for bank deposits. So even if the bankgoes bankrupt, the individual bank depositors won't lose their money.

So a bank deposit is very safe, but it has a low return. If youinvest in bonds, either directly or through, say, a wealth management account runby a bank, you get somewhat higher return. But that return isn't guaranteed anymore. And if a company issues a bond and the company goes bankrupt, you couldeven lose some of your money. So there's more gain, but there's also more risk.What about investing in stocks, either directly or in some kind of a fund?Again, if the companies do very well, you could get a very high return.

If they do very poorly, you could have a very low return. On average,the average expected return will be higher then with bank accounts or bonds tomake up for that extra risk. But there's no guarantee. Again, there's atradeoff between risk and return.

The third category of investments is called liquidity. And liquidityis a word that might not be familiar to you. It's mainly used by economists andprofessional investors, but saying an investment is liquid just means that easyto turn that investment into money you can spend.

For example, a bank account is very, very, very liquid, because youcan spend it right away. On the other end, owning a house is not very liquid,because you can turn it into cash eventually, but you have to go through theprocess of selling it. And that's not going to be necessarily quick or easy.Owning stocks are not quite as liquid as a bank account. You can't just gospend the money, but it's easier to sell a stock than it is to sell a house. Sothat kind of  falls in between.

Now liquidity matters to you as an investor, because most peopleneed some liquidity. Maybe you get sick. Maybe a family member needs help.Maybe you need to move or change jobs, and you need some money. Right now youneed some liquid money. There's also usually a tradeoff between liquidity andlevel of return. Investments that are very, very liquid usually pay a lowerreturn. In fact, if you think about it, cash is the most liquid thing of all, andit has no real return at all investments where you have to lock up your moneyfor some time. And it's hard withdraw that money. They can have risk. Theymight do better or worse, but on average, they will tend to pay a higher returnto compensate you for locking up your money.

The fourth and final category I want to talk about is taxes. Whenyou make an investment and earn income, you have to pay taxes. Now, tax lawsare different in every country, and I'm certainly no expert on Chinese tax law.But I will say that many countries have tax laws that give just a littleencouragement to financial investors who own the asset for a longer period oftime, as opposed to someone who's buying and selling in shorter periods oftime. Here are a couple of examples from China. In China, if you own stock in acompany and the company pays you dividends, the tax you pay will be higher onthose dividends, if you own the stock for only a short time. Or if you own andlive in a house for at least five years and then sell it, that higher valuewill not be taxed.

The overall lesson here is just beware of the tax rules. They canmake a real difference. Now, I started off this lecture telling you, I didn'thave an easy recipe for getting rich, and I don't, but here are a few lessonsyou could consider. Most people, if they don't win the lottery or start acompany that makes them rich, they need to get rich over their lifetime bysaving money. And if that's going to work, you need to start saving when you'rerelatively young and try to continue saving pretty steadily throughout yourentire life. It gives lots of time for the return to accumulate over time.

Another lesson is that you need to be willing to take a little bitof risk with your savings. Consider this example, say you're putting aside onethousand yuan when you're twenty five years old, but you want to be really safewith that money. So you put it in a bank account and you get a one percentreturn. It's very low risk. It's very safe. And after thirty years of gettingthat one percent return, the one thousand yuan will have grown to one thousandthree hundred and forty eight yuan.

But what if you take that one thousand yuan when you're twenty fiveyears old and you do something with more risk, like a diversified group ofinvestments in stocks, it goes up and down year by year. But over time, let'ssay it averages a five percent return. After thirty years with a five percentreturn, your one thousand yuan will have added up to four thousand threehundred and twenty two yuan. You want what looks like a fairly small differencein return. One percent a year versus five percent a year really adds up to ahuge difference over long periods of time.

So think about for yourself. What can I afford to save, even if I'mrelatively young, just so I can get started now and let it build up overtime.What liquidity do I need? And you do need some liquidity and what risk am Iwilling to take when planning for the long run? Because being too safe can bejust as bad as being too risky.

 I'm Timothy Taylor. Thanksfor listening to Himalaya.