The Financial Group
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THE EDUCATION SECTION November 2016 A guide to Investment Risk & Return What is Risk? Over the past few years, ‘risk’ has become a popular term in the context of investments. This is in part due to the fact that the 2008 financial crisis showed how many investors were unsure or unclear about what risks they had been taking with their investments. Before 2008 there have been many times when uncertainty has arisen eg: 9/11 of 2001 & Black Monday of 1987. The word risk, even within the narrow scope of investing, can be viewed in many different ways. One distinction we can make is between investOR risk and investMENT risk . What is investor risk? Investor risk can be described as the possibility of not being able to match your future outgoings with the savings pot you’ve accumulated for this purpose - eg: your pension fund. This risk is managed by financial advisers when they gather information regarding the future cash flow requirements of a client, and advise accordingly. What is investment risk? ‘Investment risk’ is different - it describes the fluctuations in value of a portfolio over time. For many of our clients, the main concern is loss of capital. While this is applicable in the case of highly concentrated investments (such as a few stocks or shares) it is less applicable in the case of a diversified portfolio. Here, the risk of total loss is spread across each of a large number of investments. This means that instead of looking solely at potential loss, we focus on the predictability of expected returns. We measure this predictability using volatility. How do we work out the route forward? The starting point is our Risk Questionnaire. We have put together a range of questions, together with our partners FE Analytics, to produce a report that we use as a discussion document that we can talk through with you to help understand your thoughts on your investments & the ‘risks’ that you are happy to take to achieve your goals. None of the answers are ‘set in stone’. They & the report just help you & us enormously when we are discussing the best route forward. Click the Risk Questionnaire image if you would like to complete our Risk Questionnaire & receive a report summarising your answers & our interpretaion of your Risk level. What is volatility? Mathematically, volatility is the standard deviation of annual returns. (Wow! Need an explanation? Find out here .) Under normal market conditions, this describes the range of returns around the average you would expect to see in 2 years out of 3. Clearly, these past few years have shown that markets don’t always behave ‘normally’, and we can see returns which are much higher or lower than expected. What does this mean for you as an investor? There is a need to find a balance between the level of predictability you wish to have in your investment return, and the level of return you are aiming for. There is of course a trade-off to be made here - asset classes with highly predictable returns, such as cash or gilts, offer little by way of a ‘premium’, while asset classes which experience greater fluctuations, such as equities, can offer higher returns, but with less ability to predict whether or not you’ll achieve these higher levels. Managing your Investment Risk. Once we have determined the level of predictability you wish to have, the aim of investing is then to manage this as efficiently as possible. In other words, to maximise your potential return while maintaining the same level of predictability about that return. There are 2 tools that are effective in achieving this - diversification and compounding . Diversification. Bond prices, which benefit from falling interest rates and fear in equity markets, often rise while equities are falling, and this low correlation can reduce the overall portfolio volatility without materially impacting the expected return. This effect can become amplified when you begin to introduce alternative asset classes such as property or commodities. A balanced portfolio, comprising of equities, bonds and alternatives, should therefore produce superior returns per unit volatility compared with the individual asset classes. Compounding - refers to holding an investment for a longer period of time, meaning there’s a greater likelihood of achieving the expected annual return. By increasing the amount of time that the investment is held for, the impact of annual variation in portfolio returns can be minimised. The chart on the right shows the maximum and minimum annualised real returns of UK equities since 1985, showing how the return on an investment becomes more predictable as the time horizon increases. The average annual return realised over this timeframe doesn’t really differ and sits at around 7% per annum, but holding the investment for 10 years rather than 1, 3, or 5 years significantly increases the likelihood of realising the expected annual return. As always, please do not hesitate to contact us if you would like further details or information.