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Why bank stocks can be risky investments

Australia’s economy is in a state of transition and politicians are hoping investors will transfer investment from resources projects into other areas like financial services, retail and property. That’s unlikely.

With interest rates dropping, international investors will see less benefit from keeping their funds in Australia and as the dollar drops, foreign exchange rates will start eating away at gains they make. Some tip the dollar to go as low as 60 cents.

Just like international investors, local investors may take their money and look elsewhere and who could blame them? Playing the currency is a great way to take advantage of gains in foreign markets, like the US, whose market has performed exceptionally well since November 2012. Keeping money in term deposits seems foolish.

As interest rates drop lower, many investors holding cash will see the transition from a term deposit to shares in the same bank as a plausible strategy to take advantage of good yields, sometimes as high as 9% with full franking. However, this type of investing has proven time and again that it can be a very poor investment strategy.

Between April and June, we seen this strategy played out too many times, only for the investor to get stung with losses of up to 18% in less than a month and possibly without any dividends.

Investing is a long-term endeavour; trading is something different altogether. Finding good companies with growth potential and dividends for investment over a certain period, perhaps five years, is the best way for investors to get some sleep knowing their money is safe.

Banks such as NAB (ASX: NAB), Westpac (ASX: WBC) and Commonwealth (ASX: CBA) are perfect examples of stocks progressing towards the expensive end of town. NAB and Westpac are stocks an investor would buy for income, and despite having a good yield Westpac is too expensive for this investor. Commonwealth bank is already the biggest in Australia and cannot grow much bigger without a serious change in the business model or expansion overseas, so it’s anyone’s guess why investors are buying it above $72 per share (a P/E of over 15). My bet is its ‘safety’ factor.

Any good financial planner, advisor or broker should tell you the best way to mitigate risk is to diversify. If a company relies so heavily on one market to create returns, it can struggle to maintain an upward trending profit if that market takes a turn for the worst.

As investment in Australia’s mining sector shrivels, we will see the effects ripple through interest rates, the AUD and back to the banks. Counterintuitively, their share prices are trending higher, making traders look good.

Finding an investing service that helps you to make the right decisions and provides a sensible window for investment is perhaps the best investment serious investors make. Buying stocks cheap is the best way to make money and is the reason this investor isn’t buying any of the stocks above.

However, ANZ (ASX: ANZ) is a banking favourite that allows investors to escape the Australian banks, which are so highly leveraged on mortgages and domestic growth, by taking advantage of investment throughout Asia and beyond.

By 2017, the company is targeting 25% to 30% of revenue from its overseas business. The bank is already building a solid reputation throughout Asia but hasn’t forgotten to remain locally competitive. It still remains the most efficient lender by return on equity.

Foolish takeaway

Contrary to the belief of academics, sometimes the market doesn’t get it right, and at the moment the biggest risk for an investor buying bank stocks is doing what the market is doing. Don’t be fooled by dwindling dividend yields and a huge market capital. Australia’s biggest banks are likely to witness a credit crunch and it will be evident when their customer deposit to loan ratios are lower than in the first half to 31 December 2012.

If you would like exposure to the sector, ANZ is the cheapest in terms of growth potential and current share price and has a solid 5% fully franked yield. It’s also opening its doors to more depositors and businesses throughout Asia and which will further diversify its exposure to Australian markets.

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Motley Fool contributor Owen Raszkiewicz owns shares in ANZ.

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