Getting to grips with the concept of risk and how it interacts with the investment process is possibly the most important thing any potential investor should understand. It is a complex subject though with many constituent parts so can often be difficult to tie down and define.
The purpose of this document is to provide you with an understanding of the different risks that investments are exposed to. It will go on to illustrate the ways we as investment managers try to manage those risks as well as explaining the type of things that you need to consider when deciding on the type of investment which is right for you.
What do we mean by risk?
When it comes to investments, risk is all about the possibility that your investment could fall in value as well as rise. Everyone looking to make an investment does so for the opportunity to make positive returns but in doing so, they must accept the possibility that they could leave the process with less money than they started.
All investments carry a certain degree of risk, it is unavoidable and drives the returns that we hope to make.
Risk vs Return
Returns from investment are inextricably linked to risk. The level of returns you can expect to make are dependent on the level of risk you are willing to take on. In general, the higher the risk, the higher the compensation the investor should receive in the form of returns, but this is not always the case.
Unfortunately, by taking on more risk the chance of losing money increases as well. Our job as investment managers is to achieve the optimum level of return for any given level of risk.
So what are the risks?
The range of risks affecting investments is very broad and wide reaching. They can range from high level socio-economic concerns such as war or political turmoil to more company specific problems like bankruptcy caused by the actions of a rogue trader.
Below are a few of the key risks the investments we use are likely to be subject to;
Government policy and social issues have wide reaching consequences for the value of investments. Regulation can stifle industry just as favourable tax breaks can benefit it. Decisions made by politicians as well as public sentiment, need to be carefully considered when assessing risk.
The risk that the prevailing interest rates can be detrimental to the value of your investments. A rising interest rate environment can cause the value of fixed interest investments to fall as the fixed interest rate they offer is no longer competitive.
The risk that the value of an investment held in a foreign currency falls as a result of a change in the exchange rate. The value of shares in an American company held by a UK investor may grow in dollar terms but if the exchange rates move adversely the sterling value of that investment could fall regardless.
The risk that the real value of your savings will be eroded by inflation. Savings need to keep pace with prevailing inflation or you will in effect be losing money in real terms. This is often considered the risk of not investing because if you leave money in a bank account paying interest at a rate below inflation, you are effectively losing money.
The risk that the value of an investment cannot be realised quickly because there are insufficient buyers in the market. This is a problem in a falling market as an investor is unable to sell quickly without accepting a much reduced price. This risk is more relevant to property investing or with unlisted companies because they do not have the high volumes of trading activity that FTSE 100 companies might have.
The above are just a few of the risks associated with investing. Some of them can be anticipated and present themselves with common regularity. Others are completely unpredictable. Unprecedented world events occur all of the time and it is impossible to predict them.
Although it is not possible to predict what is going to happen, it is possible to manage your exposure to potential problems. Our role is to design portfolios that can withstand shocks from unexpected sources whilst offering the opportunity for growth.
This process is done through a variety of means from appropriate asset allocation through to ensuring you have adequate diversification. Risk are manageable because different classes of assets are affected by the risks detailed above to different degrees.
For example, government debt or corporate bonds are conventionally considered “less risky” than equity because historically their values do not fluctuate up and down as much. Similarly, large well-established companies are less likely to go bankrupt than new start ups and accordingly are considered less risky.
By changing the allocation to different kinds of assets, the risk profile of a portfolio can be adjusted. Striking the right balance across all these different asset classes is what good investment management is all about.
Risk and the individual
As part of our advisory process we look to assess the level of risk you are willing to tolerate. This is a very important step and will have a big impact on the kind of recommendations we might make for you.
We will look to agree a risk profile for your investment portfolio and we will then manage your portfolio within the risk parameters that we agree with you. These parameters can be narrow or they can be a bit wider depending on the level of discretion you are willing to give us. At Money on Toast, we only work with regulated products and the risk categories described below are in relation to regulated products. We work to 5 core risk profiles and the below description will give you an understanding of what each risk category means in plain English.
You would generally prefer to avoid the volatility of stock market investment and prepared to accept the inflationary risk that that implies. You want to steer clear of equities and have all of your money in Cash, Gilts and equivalents.
You’d rather have a scenario where, if you make a gain, it is a small gain, because then any losses will likely be small too. You may not have much investment experience and you are willing to forgo high investment returns for the relative security this offers. You want high exposure to Cash, Gilts and equivalents and only want limited exposure to Equities.
You would like to ensure your short term financial security through low risk investments but also wish to benefit from the long term investment prospects provided by equities. You don’t want your Equity exposure to ever be excessive.
You would like some investment in higher risk investments which carry the risk of potential loss of capital but not to the detriment of either your long term or short term financial security. You are happy to have 100% of your portfolio in equity at times if market conditions dictate.
You are prepared for the possibility of large losses as well as large gains. You would like considerable exposure to higher risk investments despite the potential loss of capital. You like your investments to incorporate up-and-coming economies.
Risk and our Managed Portfolio Service
The Managed Portfolio Service is our core investment services. Via the MPS we run a series of different portfolios which are kept within the defined risk parameters at all times. Each portfolio is run with set risk-focused strategy ranging from very cautious through to very adventurous as described above.
The level of risk each portfolio is exposed to is designed to be kept constant at all times. This means that we will not materially change the exposure to risk assets just because they happen to be doing well at a certain point in time.
Through this commitment to fundamentals we can ration the level of risk you, as an investor, are exposed to. If you decide that your circumstances have changed and you would like to take on more or less risk with your investments, then you can simply let us know and we will link your holdings to a more or less adventurous strategy. We will not however do this without your prior consent.