Risk and reward are related
However, it is important to distinguish between good risk and bad risk, as taking on unnecessary risk can leave your portfolio exposed to increased potential for loss. However, higher exposure to the right risk factors leads to higher expected returns, but is not necessarily a guarantee of them. Risk is the premium investors pay for the expectation of a greater return.
Our role as your adviser is first to identify which risks offer consistently higher expected returns and which do not, and then to offer you exposure to those risks in a structured, disciplined, cost-effective way.
There is a well-respected relationship within the investment community that goes along the lines that, the higher the target return, the more risk an investor must take. As a result, when constructing an investment portfolio, it is important that the investor determines the amount of risk that they are prepared to take, as this will have a direct consequence on the asset allocation within the portfolio. In order to determine this, the investor must ask themselves a number of key questions:
Do you understand the type of risks that you are exposed to?
Investment risk can come in various guises and in order to position your portfolio correctly, it is important that you are aware of and understand them.
What is the time horizon of the investment?
The longer the time horizon, the longer the portfolio will have to recover from a significant drawdown. Thus, investors looking to crystalise their investment in the short term should look to limit exposure to risky assets.
What is your attitude to risk?
Here, it is important to distinguish between risk appetite and capacity for risk. While the investor may be prepared to take a higher level of risk in order to benefit from higher gains, they may not have the capacity for potential loss. Thus, the investors risk profile can be pre-determined by circumstances, such as near retirement, lack of excess capital or the need to remain liquid.
Once the risk profile has been established, the correct asset allocation can be established.
History tells us that different asset classes have different risk and reward profiles. The graph below illustrates the risk and return profiles of the most commonly utilised asset classes.
While past performance cannot guarantee future results, each asset class has a varying degree of risk and potential to over- or underperform over any specified period of time. However, over the long term, the relationship illustrated here tends to hold.
The risk profile and asset allocation are then used to construct the investment portfolio according to modern portfolio theory, utilising the benefits of diversification. Diversification is not only across sectors, but also across geographical regions and asset class. This helps to mitigate potential risks as investments that tend not to rise and fall in tandem will limit exposure to systemic risk and therefore offers an additional tool with which to manage the overall risk of the portfolio.
Types of risk
Inflation is like a stealth tax, eating away at the value of money. You won’t see a smaller cash balance in your account, but you will definitely lose buying power. In other words, the amount that you can purchase with each Pound in your pocket slowly decreases over time.
Many savings accounts fail to pay a return that beats inflation, especially after tax is deducted. So even if you reinvest every penny of your interest, the real value of your savings could fall.
Economic and political risk
Economic and political factors play an important role in the performance of investment markets. Economic factors include economic growth, inflation, employment, interest rates and business sentiment, while political risk includes changes in government, political uncertainty and international conflicts.
This refers to the risk of failing to meet your long-term investment target. This could mean that you didn’t take on enough risk to get the potentially higher rewards or that you took on too much risk and your portfolio fell in value.
For example, if you are saving for your retirement, putting all your money into a savings account may not build enough capital to produce the income you will need in retirement. On the other hand, you could also be exposed to shortfall risk if you invest in too many high risk assets causing your portfolio to lose value at the wrong time. So investing too aggressively or too conservatively can each lead to shortfall risk.
The risk that domestic events – such as political upheaval, financial troubles or natural disasters – will weaken a country’s financial markets.
Credit or default risk
The possibility that a bond issuer will fail to repay interest and capital on time. Funds that invest in bonds are exposed to credit risk.
The risk that changes in currency exchange rates cause the value of an investment to decline.
Interest rate risk
The possibility that the prices of bonds will fall if interest rates rise.
The chance that an investment will be difficult to buy or sell.
The chance that a pooled fund will under-perform due to poor investment decisions.
The risk that any market such as equities, bonds, property or cash, may decline.
The risk that a particular sector within a market, such as the oil and gas sector, or the travel sector, may decline in value. For example, if oil prices surge, the oil and gas sector might rise whereas the travel sector might fall due to rising fuel costs.
The risk that a specific share, bond or fund you’ve invested in performs badly.
As we saw earlier, different types of investments fluctuate in value over time. This is referred to as volatility and is often used to assess the potential risk associated with an investment.