Measuring Risk

Risk has objective elements, but it’s also dependent on the attitude of the individual. 

One person’s idea of a less risky investment might be another person’s idea of a higher risk investment. 

Volatility can be measured, but of the various methods, the only relatively accessible one is “standard deviation”, which shows how much the price of an investment varies from its average.

There have been several scandals in recent years, where people who believed they had invested in a “low-risk” investment were shocked to discover it could fall in value.

When financial advisers and commentators use the words low-risk, they generally mean an investment with a record of comparatively low volatility. But just because an investment does not usually experience big price fluctuations, does not mean it cannot.

For example, in January 2015 the yield on UK 10 year fixed Gilts fell by 5.5 basis points to the lowest level in UK history​.

IS THERE SUCH A THING AS NO-RISK INVESTMENT?

Unfortunately not. Even capital guaranteed products can lose money in real terms, as over time capital will be eroded by inflation. In addition, with any product offering guarantees, investors should also question who is providing the guarantees and what level of financial security they enjoy.

Thousands of UK investors in products backed by Lehman Brothers found to their cost recently that a guarantee is only as good as the institution which issues the guarantee.

National Savings and Investments index-linked certificates carry the lowest risk of loss, paying tax-free interest and guaranteeing to increase capital in line with inflation over a set term, usually five years.

These are backed by the UK government, the only risk of loss lies in the unlikely event of government bankruptcy, or in the penalties for early withdrawal.

At the other end of the scale, extremely speculative investments like derivatives, with the chance of losing more than the original investment, are undeniably high-risk.

In between definitions become harder to pin down, particularly as the risk of loss must be weighed against the risk of low returns. Which type of risk represents the biggest worry will vary from person to person, and will depend on their investment goals and constraints. The most important of these constraints is investment timescale.

TIMESCALE

The amount of time before access to savings is needed is crucial to judging the level of risk taken with them. 

The longer the time frame, the more the danger of poor returns outweighs the risk of loss.

By contrast, those needing access to their all of their money within a few years are likely to attach heavy importance to capital security. Someone saving for less than five years should generally stay clear of shares, or any equity-linked investment, as they run a higher risk of getting back less than they invest.

For longer timescales equities do provide higher potential returns. Since 1900 shares have provided a higher return than cash over 10 year periods for 90% of the time. 

NOTE: please remember past performance is not a guide to future returns.

Property is also a medium to long-term investment, particularly for those buying actual bricks and mortar. 

They not only face the risk of a fall in property prices just before they need to cash in, but also the danger they will not be able to find a buyer when they want one. There are also high acquisition and disposal costs involved with investments in an individual property.

The risks of fixed interest securities for short-term investors depend on their redemption date and price. Bond-holders know to the penny the interest they will get between purchase and redemption. However, both income and capital payments rely on the issuer not defaulting. They are therefore not guaranteed.

Short-term investors who need to ensure capital security could opt for short-dated gilts (those with less than five years to go) with a redemption date just before they need the cash.

All investors buying investment funds or other packaged products should check carefully to see if they might suffer exit penalties or loss of interest by cashing in before a certain point. With-profits bonds, for example, often impose surrender penalties in the first five years, while fixed rate deposit accounts may cut interest in the event of early withdrawal.

For long-term investors, capital security tends to be outweighed by the need to grow their investments as much as possible. This typically means a sizeable amount in equities, ideally spread over a range of different markets, sectors and shares. The danger of price falls is always there, but the longer the timescale, the more likely it is they will be offset by previous, or subsequent gains.

Bear in mind investment timescale will decrease over time. Those investing for their retirement and intend to use most of their fund to purchase an annuity (guaranteed income) for example, should consider gradually moving to a more cautious asset allocation in the final years before the money is needed (say over a 5 years period).

The long term is merely a series of short terms added together, so the closer the event for which the money is needed, the bigger the threat posed by volatility.

Income or Growth Investment Strategy?

This is an important question and when considering the answer be careful not to ignore the concept of total return.  Total return looks to combine income with capital growth to achieve the best overall return.

One example of this is equity income funds, where investors saving for retirement could reinvest the income until the day they retire and then elect to have it paid to them instead, producing an income without the costs of completely overhauling their portfolio.

Index-linked investments, such as certain gilts and National Savings certificates, can protect against inflation eroding capital and income, but in today’s low-inflation world investors need to compare the total return to that available from an ordinary gilt or savings account.

Wealthier investors, who can cope with a little fluctuation in their income and capital, could look to include corporate bonds, property and dividend paying shares. Bonds and property traditionally pay higher yields than equity income shares, but equities have provided the greatest opportunity for capital growth and growth of income. 

A balance between the different asset types should provide the best chance for a reasonable and growing income.

Income-paying equity, bond and property funds can be a good investment for those investing for capital growth too, as it’s simple to arrange for income to be reinvested.

The amount a person can afford to invest has a bearing on the amount of risk they take. 

A wealthy person with a large sum to invest can probably afford to take more risk than someone with just a small amount to stash away…

INVESTMENT AMOUNT

The amount a person can afford to invest has a bearing on the amount of risk they take. 

A wealthy person with a large sum to invest can probably afford to take more risk than someone with just a small amount to stash away. However, the wealthier they are, the less need they have to take risk.

However, even if an investment is for the long term, it is still necessary to ensure the short term is covered. 

This means putting aside a capital sum in a high-interest easy access savings account, sufficient to cover both anticipated spending over the next few years, and any emergencies that might arise. It should be enough to provide a cushion in the event of unemployment, as well as an extra sum for covering domestic or
medical emergencies.

This means the cash part of any portfolio always comes first. Until a sufficient cash buffer is built up, there is no point in investing in more volatile investments or those with early exit penalties. Otherwise there is the risk of being forced to sell in a hurry, and getting back less than the original investment.

Even once a cash buffer is in place, the amount of risk taken is dictated by the investment amount. Someone with a few thousand pounds to invest shouldn’t really be buying individual shares, for example, as they won’t be able to afford the spread of investments necessary to reduce volatility to the market average. A better bet would be collective investment funds such as unit trusts, which typically invest in at least 40 to 50 stocks.

Investors who don’t have a lump sum, but can put away a regular amount each month, should consider unit trusts, OEICs and investment trusts, many of which will accept regular savings from £50 a month. This can reduce the risk from volatility through 'pound-cost averaging'. In other words as the fund’s value moves up and down, less is paid for each unit or investment trust share in some months and more in others, giving a long-term average purchase price. 

This should iron out short-term ups and downs, resulting in – hopefully – a gradually increasing fund.

Planning investments according to risk profile can help reduce unnecessary risk, but they will still be subject to a whole host of influences outside the investor’s control..

Risk factors you can’t control

Planning investments according to risk profile can help reduce unnecessary risk, but 

they will still be subject to a whole host of influences outside the investor’s control.

Inflation

Inflation poses a serious risk, as it erodes both capital and income. In the 1970s, inflation ran at an average of 13% (reaching a horrifying 25% in 1975). Even equities, still the decade’s best performing asset, failed to keep pace, with an average loss after inflation of 2.1% a year. Even with low inflation, defending capital and the spending power of returns should be a priority.

Inflation hits lower returns disproportionately hard. Over the past 40 years (1971 to 2010) equities have enjoyed average returns of 12.0% a year, while cash managed 7.3% – great by today’s low interest standards. 

After taking inflation into account, equities’ real average annual return was cut by just over a half to 5.3%. But cash returns were much harder hit, falling to 1.0%, around a seventh of their nominal return.

Many investors have not got used to a low-inflation environment, and as a result often take on more risk than they should in their attempt to replicate the double-digit returns paid on savings accounts ten or more years ago. Investors comparing the 0.2% paid on a typical building society savings account in 2010 with the 12.9% they would have got in 1981, (source Barclays Capital Equity Gilt Study), might feel hard done by. Yet in real terms the returns were very similar. Inflation in 2010 was almost 5%, but was running at 12% in 1981 making an even bigger dent in savers’ buying power.

CURRENCY EXCHANGE RATES

Investing in foreign shares, bonds or property, either directly or within a fund, carries the added risk of currency fluctuation.  If the Pound strengthens against the currency in question, the investments will buy fewer Pounds, meaning any gain could be reduced. 

On the other hand, a weaker Pound would enhance foreign returns in Sterling terms. 

Some funds are now hedged to offset this risk.

INTEREST RATES

If interest rates rise it’s clearly good news for cash savers on variable rate accounts. But it’s bad news for other types of asset, as it makes their yields less attractive by comparison. Investors holding shares in companies with high levels of debt, such as manufacturing firms, could be hit hard, as will buy-to-let property investors with variable rate mortgages. Corporate bond and Gilt investors could also be adversely affected by rising interest rates.

POLITICAL CHANGE

A new government, in the UK or elsewhere, can mean big changes for a country’s economy, which can affect all types of investment as a result of interest rates and inflation rising or falling. In addition, government reforms on investment rules and tax allowances can dramatically alter the relative attractiveness of certain products.

INDUSTRIAL CHANGE

Over time stock market sectors rise or fall in importance. Worldwide technology, media and telecoms companies are much more important than they were a decade ago, for instance, and the UK service industries have overtaken manufacturing in importance. 

Broad-based investment funds can follow these changes more easily than sector-specific funds, and also tend to be less volatile.

War, terrorist acts and natural disasters, earthquakes and floods can cause severe disruption to the economies and markets of the countries affected. But the threat of war or terrorist attacks can hit stock markets around the world.

FEAR AND GREED

Fundamental factors like company prospects are usually the main drivers of share prices. However, market sentiment always plays some part in share prices too. 

Occasionally, however, investors’ greed pushes share prices up to unsustainable levels. 

The bursting of that bubble induces a hefty dose of fear which pushes them right back down. Cautious investors will always consider taking profits to reduce the impact of such bubbles.

FRAUD AND/OR DEFAULT

This should be less of a problem than it used to be, as a result of tighter regulation by financial watchdogs and the fact most investment products sold in the UK are covered by the Financial Services Compensation Scheme. 

Those investing in direct shares (including investment trusts) or bonds, however, are not covered by the scheme, and what has happened to Enron and more recently the Northern Rock has highlighted the dangers in this area.

When a company goes into liquidation, bond-holders have the first rights to any money owed to them after the banks, while shareholders are last in line. Sometimes there may be nothing there to pay even the bond-holders as in the case of Barings’ collapse in 1995.  Likewise the Madoff scandal which came to light in 2009 highlights the risk of investor fraud.

Furthermore, one type of fraud is on the increase in the UK. Unregulated brokers make unsolicited calls to investors, proposing they buy shares in a particular company. The shares are usually worthless or very difficult to sell, and the unscrupulous ‘broker’ simply pockets the cash. These are known as ‘boiler-room’ scams, because of the highly pressurised sales techniques used by the caller.

The golden rule is never to purchase an investment from a company which cold-calls – they have already broken the law by doing so – and always check a broker is FCA-regulated before doing business with them. You can check this on the FCA website.