Investment Risk & Oil Prices

Risk: The chance that an investment’s actual return will differ from the expected return.

It is because of this uncertainty of return that investors deserve a risk premium.

Risk Premium: An expected return greater than a risk free asset (cash/term deposits). The premium provides compensation for the risk of an investment.

From my previous emails this year, we all know that the majority of economists are predicting a bumper year for 2011. It is worthwhile skimming through this article which states Commsec’s chief economist Craig James and AMP’s economist Dr Shane Oliver both predicted high double digit returns in 2010 and that the market would end at 5,600 points. With the benefit of hindsight we know the ASX200 ended 2010 at a disappointing 4,790 points. This illustrates the definition of risk perfectly.

Domestically we now have the possibility of a new ‘carbon tax’  and the also the flood levy. Both of these will take funds from consumers and direct them to Canberra. Here, as with most taxes, they will be depleted as they swill around Canberra for a while before the remnants are allocated back out to some of us. Internationally we have continued unrest in the Middle East leading to ever increasing oil prices.

Martin Wolf, the chief economics commentator at the UK’s Financial Times, wrote yesterday that oil prices have risen above $114 a barrel which is 64% higher than May 2010. He goes on to say:

“As Gavyn Davies noted in an excellent comment on FT.com last week: “Each of the last five major downturns in global economic activity has been immediately preceded by a major spike in oil prices.” Sometimes those spikes were triggered by supply shocks, as in the 1970s. Sometimes they were triggered by demand surges, as in 2008. But the outcome was always unhappy. Stephen King of HSBC also waxed pessimistic: “Regular as clockwork, increases in oil prices of more than 100 per cent lead to declining GDP.” An oil shock has complex economic effects: it transfers income from consumers to producers; it lowers overall spending, as consumers normally cut their spending more quickly than producers increase theirs; it shifts spending away from other goods and services; it makes net oil exporting countries richer and net oil importers poorer; it raises the price level; it lowers real wages and the profitability of energy-using industries; and it reduces supply as capacity becomes uneconomic.””

The article isn’t all doom and gloom, and he states that a short term ‘price shock’ will not affect the world economies that much. This was also supported by Ben Bernanke last night – “Mr Bernanke, making his first comments since the turmoil in Libya drove US crude oil above US$100 a barrel, said he would expect higher prices to lead to only a modest, temporary increase in US inflation “at most””. The same article however does also state that:

“Mr Bernanke, who will testify for a second day before a House of Representatives committee today, also reiterated a warning that a failure by Congress to raise the US government’s US$14.3-trillion debt ceiling could lead to a devastating debt default.”It would be extremely dangerous and very likely a recovery-ending event,” he said. The US Treasury Department yesterday said the debt limit could be reached as early as April 15, 10 days later than its previous estimate.”

These issues increase the chance that our return will differ from the expected return and hence the risk in our portfolios has increased. This is why the VIX (known as the fear index and rose to prominence during the GFC) jumped 13.1 % to 20.75 last night. The index measures the cost of using options as insurance against a decline in the US’s S&P 500 index.

I personally remain hopeful that 2011 will be strong for the markets and believe that uncertain times present profitable opportunities, however we all need to be aware of the true definition of risk and assess when it’s time to reduce or increase our exposure to it.

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