Risk and Reward

The lowest-risk investment you can make is to lend money to the Government. It's vanishingly unlikely that the Government will be unable to repay its debts. So your capital is very safe: virtually no risk of losing it. Because many people want this level of safety, the Government doesn't have to offer much of a reward to get people to invest: it pays the lowest level of interest on the capital.

Companies which need funds cannot match that level of security: companies do go insolvent, even the largest, and thus there is always a greater risk of losing some or all of your capital if you lend to a company. So companies are thus forced to pay a higher rate of interest to get people to lend money to them.

So there is a direct relationship between risk and reward: the lower the risk, the lower the reward, and the higher the risk, the higher the reward. It's important to remember this, because salesmen and other unscrupulous individuals often try to paint high-reward investments as "low-risk" to get naive people to invest. But they can't be low-risk. If they were, the promoters would not need to pay high returns, because there is lots and lots of money looking for low-risk investments (pension funds mainly), and they would have no problems getting investors.

The fact is that low-risk is very hard to do. If you're not the Government, the only way to do it is to build a very large and very stable company, over many years, with a solid track record of consistent returns and prudent financial management. Because it's hard to do, there is a shortage of it, and newer companies need to attract funds by paying a higher return, until they have built up the track record that will enable them to qualify as lower-risk.

So the next time your mate tells you about a sure-fire, zero-risk investment that's paying 20% per annum, just tell him there's no such thing. Zero-risk investments never pay much above the bank rate, and investments that have to pay 20% returns to get funds must be so risky that you're one step away from gambling: what brokers euphemistically call "highly speculative". You're very likely to get no return at all, and lose your investment as well.

The Great Bank Charges Scandal

Bank charges are in the news again, with the Office of Fair Trading (OFT) taking a test case to the high court to determine whether the banks are acting unfairly when they levy overdraft fees.

There's no doubt that the fees are grossly unreasonable. But on the other hand, they are spelled out in the fine print, and you can avoid them by not exceeding your agreed overdraft limit. And banks argue that if they are prevented from charging these fees (which amount to billions of pounds a year) then they will have to end free personal banking.

Let's look at these arguments. Firstly, the notification of an unreasonable action doesn't make it reasonable. It might make it avoidable, if there were any other option: but since all banks do it, there isn't.

Secondly, I don't think many people intentionally exceed their overdraft limit: it happens from time to time due to Sod's law, despite your best efforts: why should the bank make money from that? The decision to grant credit could be completely automated (in fact, it probably already is), and if an exceeded overdraft resulted in a bounced cheque, the inconvenience of that would be penalty enough for the hapless account holder, without adding a huge financial penalty on top as well. Especially when multiple charges are levied.

Finally, the threat of the end of free banking. So what? Personal banking is not really free now: there's the pitiful interest paid on current account balances for a start, and then there's the whole penalty fee issue itself, which obviously pays for the "free" banking at the moment. So we are really talking about an issue of fee transparency: how easy is it to know in advance how much you will be charged?

Instead of charging a monthly account fee and a transaction fee for each cheque, which would enable you to know exactly how much your banking costs you, you have the current fiction of "free" banking, coupled with the uncertainty of knowing that any time you take your attention off your account, you could be hit with a couple of hundred pounds of charges, probably when you can least afford it. Which would you prefer?

It's kind of like London Underground saying that you can travel on the Tube for free, but if you ever put your foot over the yellow line, play your music too loudly, or don't move down inside the carriage, you'll get hit with a £2,000 fine.

The name's Bond. Premium Bond.

Just saw some interesting research on premium bonds. If you're not familiar with these, they are a type of Government bond (ie, by buying them, you are lending money to the British Government), which means a pretty safe investment: a lot would have to go wrong before the Government couldn't give you your money back. Another benefit is that the interest paid on them is tax-free.

So far, so boring: the law of risk and return, which states that the lower the risk, the lower the return, would mean a pretty low rate of interest on these, given how low-risk they are. And that would normally be the case.

However, in an effort to spice up the returns on these, the Government decided to borrow some tactics from that other great fund-raising idea, the National Lottery. So instead of paying out the interest on the bonds in the normal way, the interest on the whole fund is gathered together, and paid out as prizes to the bondholder. There are two prizes of £1 million, and a host of smaller prizes, distributed each month.

So simply by buying a few bonds, you could become an instant millionaire! And you still get your money back whenever you want it! A lot better than the Lotto, no?

Well, yes, but that's not saying much. The Lotto is an absolute and complete waste of time and money for almost everyone who plays it. And the chances of being one of the winners is so small it's almost zero. You should certainly never look at the Lotto as an investment possibility.

So we should compare Premium Bonds to other investments. And here, we can see that the same blind hope that causes people to waste money on the Lotto each week, serves to hide the fact that Premium Bonds are a very poor investment.

Not only is the interest rate pretty measly (3.8%), but the payout structure means that most bondholders don't even get that. Martin Lewis has an excellent explanation of why this should be, over at his Moneysavingexpert site.

The moral? Always do the maths, look at the bottom line, don't be dazzled by what "might happen". Look at what probably will happen. And in this case, while you hope to win a million, the reality is that in most scenarios, you will lend the money to the Government for nothing. Don't do it!