Types of Investment Risk
There are in fact many types of risk, some of which depend on the particular type of investment. A cash deposit will be subject to Interest Rate risk, Inflation risk and (as we saw in 2008), Liquidity risk and Default risk. An equity fund may suffer from Market (or Systemic) risk if an entire sector of the market falls, Country (or Geographical) risk, Currency risk or Political risk.
As a private investor, your principal concerns are likely to be:
- Absolute risk: that your investment may be less in value when you sell it than when you bought it.
- Market risk: when investments in general fall in value, either suddenly or over a period of time
- Specific risk: when an individual investment in your portfolio falls in value
- Inflation risk: the possibility that the purchasing power of assets will be eroded
- Liquidity risk: the chance that you may not be able to access funds when you need to
Your Risk Tolerance is your attitude to risk, and it is not directly related to your financial circumstances. You may, financially, be able to withstand a large fall in the value of your investments (i.e. you have a high Capacity for Loss) but emotively you would be very upset to see the value of your wealth fall by a relatively large amount.
There are a number of risk tolerance questionnaires available and we can provide one on request. In addition, it is useful to review the worst-case scenario for various asset classes and portfolios historically in order to understand the potential loss during bad year or series of years. We will look at these figures below.
Capacity for Loss
The extent to which you could sustain a fall in value of your portfolio (or other risk, such as a decline in interest rates or increase in inflation) without it affecting your income, lifestyle or needs. This will depend very much on your personal circumstances.
The time horizon of your investment objectives will have a large part to play in your Capacity for Loss. For example, a young person aged 30 investing in a pension to retire at age 65 will have a large Capacity for Loss, since a fall in value will not affect their lifestyle in the short term. Whereas a person approaching retirement may have a much lower Capacity for Loss since a fall in value will directly affect the amount of income available in the future.
Your capacity for loss can be increased by ensuring you always have sufficient Liquidity, e.g. you have enough cash available to cover your immediate plans plus a contingency fund.
Your Attitude to Risk and Capacity for Loss need to be balanced against the investment return required to have a reasonable chance of achieving your objectives. For example, if you are paying £800 pm in order to have a lump sum of £500,000 to repay a mortgage in 20 years’ time, you will require a growth rate of around 8% pa net of costs. You are unlikely to achieve your objective if you have a cautious attitude to risk and you may be in a difficult position if you have a low capacity for loss (e.g. it is uncertain your income will continue to be able to keep up the monthly payments).
Investment Risk is principally controlled by understanding all the risks associated with an asset class and selecting individual investments suitable for the client which will hopefully perform as expected. A diversified portfolio will have assets which have an uncorrelated or negatively correlated risk profile, so if one asset class decreases in value, another should increase.
In general, the more risk you are willing to take, the higher the potential rewards over a reasonable period of time. However, lower risk investments, such as cash deposits, carry the risk that the returns may not be enough to protect against inflation or meet your future income needs.
Investment risks are mitigated by diversification - investing in a range of Asset Classes (such as equities, bonds, property and commodities) and investing in a range of funds covering different Sectors (such as North America, Europe, UK, and Emerging Markets)
We are able to show the performance of this asset mix compared to the anticipated return based on historical data and indicate the level of risk by showing the maximum peak to trough fall during the last ten years:
Actual cumulative value (£269) versus anticipated value (£225)
The chart illustrates a loss of -15.7% between October 2007 and February 2009 for this portfolio. The performance over the last ten years has been growth of 6.83% per annum against an anticipated growth of 5.7% per annum.
We have listened to our clients and produced a simple, robust and transparent investment process which we hope is easy to understand. The enclosed appendices and Tactical Asset Allocation report discuss the process in more detail.