Director, Close International
The investment world can be a risky place. John Sunderland, President of CBI, said at a recent conference that, “Britain’s greatness was built on risk-taking”, but that the aftermath of two World Wars had left Britain feeling more risk averse. So, how much risk is the average investor willing to take to secure higher returns? Perhaps it does not need to be too much.
There are two basic types of investment risk, namely, Systematic Risk which is almost impossible to avoid and diversify against and will have an impact on a range of assets e.g. a world war. The second type of risk is Unsystematic Risk which is the risk associated with being invested in specific assets, i.e. holding a company stock and can be protected against by diversification. When structuring a diversified investment portfolio, we must also consider some underlying types of risk. When choosing an asset, we should assess the following: the country risk i.e. are we investing in a politically and economically secure region? The foreign exchange risks and how possible currency fluctuations may affect our returns, credit or default risk must also be analysed, or we may face an interest rate risk, which will have a direct impact on bond returns.
Risk can be measured in two ways – absolute risk and relative risk. To put it plainly, absolute risk can be defined as the end result, which looks at how much money the investment has returned and therefore calculates the risk. Relative risk compares an investment to its benchmark in order to highlight specific characteristics that may have caused an investment to perform negatively or indeed positively. Another way of looking at the two types of risk is through the time period of the investment. Absolute risk can only be realised after the event. It is practically impossible to predict the absolute risk of an investment. For example, it would be easy to assume that because an investment has performed well over three years it would continue to do so over the next three.
However, this may not be the case. New Star states in a recent article that “such a supposition is likely to have cost investors dearly during the collapse of the tech boom”. In other words, investors should not use past performance as a guide to future returns. However, it is possible to consider the relative risk of an investment both before and after an event. So, once you have analysed the risk of certain investments, how can you lessen them?
Perhaps the answer is in diversification. Investors using a fund of funds are exposed to much greater diversification. They allow investors to hold a larger range of assets and therefore dilute their exposure to risk. Ian Orton in his article “Go Global” states: “Common sense suggests that portfolios should be diversified in terms of asset classes, that is between bonds, cash, equities and property, industrial sectors and geographical markets”. However, in diversification, there are still rules that need to be followed.
New Star fund of funds’ managers Craig Heron and Mark Harris advise that, “holding a great number of funds in the portfolio may not lead to lower risk since we may be adding funds with very similar constituents. As fund of funds’ managers, we have to be careful to ensure that we do not create an unintentional overlap between funds.” In other words, by having an abundance of similar funds that have the same objectives, investors will not lessen risk. Therefore, a careful balance of varied funds could be the way to lower risk without harming better returns. So, how does it work?
Essentially, by having added diversification in your portfolio, you are effectively cushioning the blows of any volatility associated with the individual assets. Investors can feel safe in the knowledge that the volatility associated with stocks and shares, for example, can be balanced by the safer environment of fixed income securities. For those who crave an even more low risk environment it may be worth looking at the asset allocation options.
Asset allocation can work both ways. Fund managers may vary the balance between the asset classes depending on the performance of each sector. For example, on a bullish market, the weighting of the equity sector may increase. On the downside, this does mean that, should any external shocks cause markets to fall rapidly, investors may find themselves with a potential for greater losses. However, if you are in an investment product which provides this diversification but without any allocation bets, the investor can be well assured that, if the markets should fall, they have the same weighting in four or five other classes to cushion the blow.
So it is clear that diversification can lower the risk profile of your investment. But, how does it better your returns? Let’s take, for example, a combination of property, equities and fixed income securities. Each of these classes has proved, over time, that they can produce more attractive returns than money on deposit. So the combination of higher returns and the minimisation of volatility should, over time, result in a return comfortably above bank deposit rates.
Investing your savings can be a daunting prospect at any time, particularly when equity markets have been so volatile with interest rates so low. Generally speaking, most of us are risk averse and if we are going to accept any risk when investing our hard earned money, we will expect a return to compensate for accepting this risk. Maybe the answer here is to simply not put all your eggs in one basket.