Understanding investment risk
We all know by now that “the value of your investments may go down as well as up and you may not receive back the full amount invested”. But when we talk about investment risk, although the risk of losing money is the ultimate point to consider, there are various factors we must take into account.
Different types of investment bring different kinds and degrees of risk with them. This article explains the common ones, so when we ask you to accept a certain level of investment risk in your portfolio, you understand what we are talking about and the potential impact on the outcome for your assets.
It is important to remember that investors get paid for taking risk – this is the reward for providing capital to the markets and exposing yourself to uncertainty. It is rational to seek the highest level of return for the level of risk that it is agreed should be taken, and a well-constructed investment portfolio seeks to achieve that.
Concentration: This is the principle of ‘putting all your eggs in one basket’. A portfolio with a large proportion of its assets in a single type of investment, or a group of investments with similar characteristics, has higher concentration risk. This risk can be reduced by owning a well-diversified portfolio.
Counter-party Risk: When an investment takes place, such as a transaction involving a fund or a transaction within a fund, there are at least two parties involved – the buyer and the seller enter into a contract. Each party bears the risk that the other defaults on their side of the contract. Counter-parties are typically monitored very closely to protect investors from counter-party default.
Credit/Default Risk: If a borrower does badly it might not be able to meet the interest payments or final capital repayment due on the bonds it has issued. Default risk is typically considered to be the lowest for governments as they can usually print more money / raise taxes in order to repay debt. Corporates and some emerging market governments are monitored closely for their financial strength so that investors can gauge the amount of default risk they might face. Ratings organisations place borrowers on a sliding scale to indicate to investors where default risks might be higher.
Currency Risk: When Sterling is invested in overseas assets the investment is exposed to exchange rate movements. If the Sterling exchange rate gets stronger, the value of overseas assets falls; if the pound weakens, the value of overseas assets increases.
Financial Risk: This refers to the elements that impact the value of investments, such as interest rate risk, currency risk, market risk, default risk, etc.
Geopolitical Risk: This is the risk that an investment’s return could suffer as a result of political events, changes or instability in a particular country that it is exposed to, including its home country or the country that the company invested in does business. Emerging markets are often considered to have higher geopolitical risk than others.
Interest Rate Risk: The capital value of fixed income assets changes as interest rates rise and fall. Typically, falling when rates rise and increasing when rates fall. Bonds with a longer time to maturity are often the most sensitive to changes in interest rates.
Key Man Risk: When a fund is managed by a key individual, the return achieved is very dependent on that one individual’s success. An individual with a strong track record could experience a period of poor performance; they might leave the organisation meaning the fund moves to a new manager or that the fund itself moves to a new organisation.
Liquidity Risk: This addresses accessibility of the investor’s wealth – certain types of investment are less easy to convert to cash than others. Bank deposits (other than longer duration Term Deposits) have low liquidity risk as they can easily be accessed should the investor have a cash need. Property is often considered illiquid as it can take a long time to sell to meet a cash requirement without destroying value. Financial planning considers the investor’s likely cash needs when allocating to different types of investment to allow for liquidity constraints.
Market Risk: When investing in capital markets, investors are exposing their own capital to the market fluctuations that are caused by general economic factors such as interest rates, inflation, tax rates, political factors and sentiment.
Non-financial Risk: This refers to risks that the investor is exposed to that are not included within the set of financial risks, such as tax/legal/regulatory regime change, counter-party risk, operational risk. Changes in these areas may unexpectedly increase the cost of investing and lower the investor’s net returns.
Opportunity Cost: When deciding to invest in a particular asset, the investor is giving up the opportunity to invest in all the other assets available, which might have provided superior or inferior returns. Opportunity cost is the benefit of those alternatives that are given up to take a particular course of action.
Specific Risk: As well as being exposed to the general factors described as part of market risk, individual securities are exposed to factors that are particular to individual companies, e.g. the success of an oil drilling project. This kind of risk can be diversified away by owning a broad market portfolio since each company has its own set of drivers.
Uncertainty of Income: When investing in shares and certain bonds, investors do not have a guaranteed income stream. Dividend levels can increase or decrease in line with companies’ profitability and policies; floating rate or index-linked bond income can change based on market factors and default can cause loss of income stream.