How to understand investment risk

It seems to be true that whilst many people invest their money, there are a great deal who fail to understand investment risk. This is despite the classic catchphrase of financial literature….”past performance may not be indicative of future results”.

An example of this in the UK recently, was the suspension and then collapse of the Neil Woodford Equity Income Fund. Woodford was previously a highly successful fund manager at Invesco Perpetual running the income and high income funds. General investors assumed that his prior performance would continue at his new fund which attracted 300,000 people, but they were instead in for a rude awakening.

Savers who invested earlier on lost up to 42% of their capital as the fund was forced to liquidate many illiquid assets which further compounded losses. The lesson to be taken from this story is to always do your own due diligence when investing to manage your investment risk exposure and ‘don’t put all your eggs in one basket”.

How to define investment risk

In finance, investment risk is the odd’s that an investment’s real return will vary from an expected outcome. It carries the chance that you will lose all or some of your money.

It is often determined by looking at historical performance and events. Standard deviation is a tool which is used to quantify the level of risk. This gauges the volatility of the price of an asset compared to it’s historical average over a given timespan.

You can learn to manage investment risk by grasping the essentials of risk and how it is measured. Understanding hazards that apply to different situations and understanding how to control them, will help you to circumvent expensive losses.

Risk vs rewardinvestment risk

Risk vs reward refers to the relationship between the aim to receive the highest possible return with the lowest level of risk. As a rule of thumb, higher degrees of risk are linked with higher expected returns and lower levels with lower returns. Everybody has a unique attitude to risk that will be linked to their age, lifestyle and personality. You must determine the level you will accept to achieve a particular return on your funds.

It’s essential to understand that high levels of risk do not guarantee high returns, but give you exposure to the potential of receiving them.

Types of investment risk

All types of investing and saving carry different levels of risk and anticipated levels of return. This danger which affects assets can classified as being either systematic or unsystematic.

Systematic

These are hazards that can alter a significant proportion of the total market or the entire market itself. Also known as market risk, it’s the chance of having investments fail as a result of causes like macroeconomic and political risk which influence the whole market. Additional systemic risks include: currency, country, sociopolitical, interest rate, inflation and liquidity. Market risk is difficult to manage via portfolio diversification.

Unsystematic

This is the chance of an investment failing as a result of industry-specific or company problems. This could be due to issues such as regulatory changes, new sector business competition, management changes or product recalls. By utilising diversification to invest in an assortment of assets it is possible to manage this hazard.

Interest rate

This is the danger that the value of an investment will alter because of a variation in the interest rate or any other rate factor such as the yield curve or spread. Bonds are specifically influenced by this rather than stocks, and so their market prices will fall as interest rates rise, and vice versa.

Foreign exchange

When you invest in foreign assets you need to be aware that that your holdings are influenced by the respective country’s currency exchange rates. You are vulnerable to variations in all assets that are priced in a currency other than your own. For example, if you live in the U.K and invest in a U.S stock, you may lose capital even if the share price increases, if the U.S dollar loses value against the pound.

Default

A default is the liability that a borrower will be incapable of paying the interest or capital on its financial commitments. This is specifically of importance for investors portfolio’s which contain bonds.

Government bonds are considered to have the lowest level of default and therefore pay the lowest rate of return. The highest level of investment risk default lies with corporate bonds and as such, these offer higher rates of return. Bonds with higher instances of default are known as ‘high yield’ or ‘junk’ bonds, and conversely bonds with low default levels are called ‘investment grade’. Ratings agencies such as Moody’s, Fitch, and Standard and Poor’s can be used to assess a bond’s status.

Business

This relates to the general feasibility of a business. For example, is the business in a position to service it’s overall expenses and make a profit by gaining enough sales and revenue. Potential hazards affecting the business could be competition, overall demand, cost of goods and profit margins. Additionally, operational expenses such as rent, production costs, salaries and administration costs are also a factor.

Geopolitical

Asset returns can deteriorate due to changes in-country or because of political uncertainty. A shift in military control, government transitions or changes to legislation or foreign policy can trigger potential dangers. This hazard becomes more of an issue as the time horizon for an investment lengthens.

Country

Emerging markets or countries weighed down with extreme debts can pose a significant investment risk, as they may not be able to fulfil their commitments. Financial assets in a country can be significantly affected if the country defaults on its debt obligations. Bonds, mutual funds, stocks, futures and options can all be affected.

Liquidity

Common in trading but also applicable to investments, liquidity means the ease with which an investor is able to sell or liquidate their holding for cash. In an illiquid market, either very few buyers are available or there may not be enough buyers for the size of asset that you are trying to liquidate. This means you may be unable to sell your assets for cash at a given point in time.

Counterparty

This refers to the odds that one member of a contractual obligation may default on their promises. Stocks, bonds, derivatives and options can be affected, and it can also apply to trading, credit, OTC and investment markets.

Managing investment risk through diversification

Diversification is the most straightforward and powerful tool to use to enable you to successfully manage your investment risk. It’s theory is formed on the interplay between risk and correlation. An assortment of investments from a range of different industries with variable amounts of correlation and risk will form the basis of a diversified investment portfolio.

Methods to gain diversification:

  • Spread your investments across many different assets including mutual funds, ETF’s, stocks, bonds and cash. Search for assets which are uncorrelated. This means that you will manage your risk more effectively as some assets will rise, covering those that may fall.
  • Holding investments that differ by region, industry, sector and market capitalisation will enable you to remain diversified. Different formats including income, value and growth will also provide benefit. If holding bonds, have a variety covering different credit ratings and maturities.
  • Hold investments that have different levels of risk. For example, small caps and emerging markets rather that just Apple stock. Also, risky and extremely volatile assets like Bitcoin if held, should have a small percentage allocation to your portfolio to guard against major losses.
  • Hedge investments. Hedging is somewhat like a ‘back up’ in case things go against you. It’s more commonly used in trading but can also be applied to investing. Gold is considered a ‘safe haven’ in times of financial turmoil and historically a hedge against inflation, so having some allocation to gold will usually give you some protection if markets fall or if there is a recession. In it’s truer sense you can use futures to hedge your positions in case your investments don’t perform as anticipated.

Diversification cannot guarantee against capital losses, but it is the most proven and consistent method to minimise investment risk whilst investing to reach your financial targets. Diversification is not a ‘set and forget’ strategy and you will need to undertake periodic ‘rebalancing‘ to keep your risk/reward levels in place.

Time horizon vs risk

You need to carefully consider your personal time horizon before you begin making investments to successfully manage risk. For example, if you are in your 20’s you are likely a long way from early retirement so you will be able to take on more risk in the hope of receiving a larger return. Conversely, if you are approaching retirement you will want to avoid risk as you will shortly be needing access to your funds, and so will want your investments to be very liquid.

Conclusion on investment risk

  • It’s the odd’s that an investment’s real return will vary from an expected outcome and carries the chance that you will lose some or all of your money.
  • There are many different forms which can affect your assets.
  • It can be effectively managed using diversification, uncorrelated assets and hedging.
  • Your time horizon for retirement needs to be deliberated when making investments.

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