What is investment risk?

An understanding of investment risk is crucial to maintaining an appropriate long-term investment strategy. Risk can, and should, be interpreted in many ways. To some people, risk means the likelihood of achieving a return below their expectations, for others it could be the chance of losing money, failing to keep pace with the cost of living or failing to meet a specific target. What all of these have in common, however, is that they relate to uncertainty.

Investing always involves a degree of risk, it’s generally understood that the higher the risk you take, the higher the potential reward but also the potential for loss. What’s often difficult is determining where you should sit along the scale of potential risk and reward, and then determining how you should design your portfolio accordingly. 

How much risk you can and should take depends on a number of different factors:

Risk tolerance  – how risk makes you feel. If you can’t sleep at night worrying about your portfolio then it’s likely you’ve taken on more risk than you’re comfortable with. On the flip side, if you’re taking too little risk, you could be disappointed by your returns or you risk inflation reducing the buying power of your money.

Risk capacity – how much you can afford to lose. We all go into investing in the hope of making money over the long-term but, in taking on risk, we accept to varying degrees that our investments might fall in value along the way. Think about what it would mean for you if your investments fell in value and make sure your portfolio reflects this.

Time horizon and objectives – if you’re investing for a longer period of time, you may be able to take on more risk in the hope of getting higher rewards because you’ve got more time to recover from any downturns. The nature of your goals is also important – if you’re investing in order to build up a sum for a specific purpose, the potential of not meeting that goal might limit the amount of risk you’re willing to take. 

Knowledge and experience – individuals with more financial and investment knowledge are generally more willing to accept investment risk. You don’t need to be an expert to start investing but you do need to be comfortable that you understand the nature of the investments you hold.

In my experience, the problem is that once you use the word ‘risk’ clients naturally fear the loss of money and research shows that the fear of losing money from investing in shares is perceived to be akin to the fear of death for many investors. Personally, I find that extraordinary but as the saying goes “There’s nowt as queer as folk.”

Interestingly advisers’ perception of investment risk is completely different to clients.’ Let me explain why by means of the following chart.

*Past performance is not a reliable indicator of future results

What this graph shows is the past performance track record of the Parmenion Strategic Passive funds over the 11 years ended in October 2020. Each coloured line represents an attitude to investment risk grade from 1, low, through 5, medium, and finally 10, high risk, and all risk grades in between. What two things stand out from this graph?

Well, firstly it is extraordinary how for every risk grade level the eventual return over 11 years is higher for every single increase in perfectly chronological order from 1 to 10.

Secondly the higher the risk grade, the greater the zig and zag of each line, or in other words the higher the attitude to investment risk grade, the greater the volatility.

So what does this prove to investors?

Well, it proves that the higher the level of investment risk the greater the return and equally the greater the volatility over a period of 10 years or more.

The main difference between the investment grades is the proportion of money invested in each of the four main asset classes of equities, property, bonds and cash.  For example at the lowest investment risk grades very little is invested in shares and much more in bonds and property whereas at the highest risk levels most of the money is invested in shares.

So is the investor taking more risk by increasing their attitude to investment risk or merely accepting greater volatility?

Well, let’s examine the true level of investment risk here. What is the real risk of losing money? Well, I would argue it is extremely low for the following reasons;

  1. The Parmenion Strategic Passive portfolio is made up of 12-15 OIECs or unit trusts. Each fund management group has £85,000 Investor Compensation Scheme Protection. Assuming a minimum of 12 fund management groups that makes a total of £1,020,000 investor protection per investor so for a couple that’s £2,040,000.
  2. Over periods of 10 years British shares have a 91% chance of beating cash and a 77% chance of beating government stocks. The longer the period in excess of 10 years the more these percentages increase.  Source: Barclays Equity Gilt Study 2018.
  3. Each fund within Parmenion’s Strategic Passive portfolio typically invests in 50 shares. So assuming a minimum of 12 funds that means the number of underlying shares is about 600.  That is a huge diversification of risk.

 

Furthermore, the UK stock market is currently at its most undervalued level compared to global stock markets since 1973. It has also been more adversely affected than most stock markets worldwide because of the UK’s management of the coronavirus pandemic. It has also emerged as the best performing large developed country in the world in vaccinating its population. This is the first example of how much better the UK can perform outside of the constraints of the EU which is itself way behind the UK in its own vaccine rollout. All of these factors combine to create an excellent foundation for UK shares growth for the next few years. 

The 2018 annual Barclays Equity Gilt Study further shows that since 1899 British stocks have returned 4.9% a year in real terms, compared to 1.3% for gilts (government stocks)  and 0.7% for cash. Over the previous decade, the respective figures were 5.8%, 2.7% and -2.5%. 

Inflation is of course a great destroyer of wealth.  Anybody who remembers living through the seventies will recall painfully that the average rate of inflation was in the teens. Tell this story to  Millenials and watch their utter surprise. Remind them of the 17% base rate in November 1979 and watch their jaws drop. Inflation is widely forecast to rise by most expert commentators. I tend to agree. When inflation rises governments inevitably increase interest rates.

The best assets to invest in when inflation rises are real assets such as shares, property and commodities, not bonds or cash.  So what should be your best strategy for increasing your investment returns and protecting your assets against inflation? Well, it boils down to the following three choices;

  • Consider increasing your attitude to investment risk
  • Invest more into the top-performing CCM Intelligent Wealth Fund (https://www.trustnet.com/factsheets/o/oxo8/ccm-intelligent-wealth-r-inc)
  • Transfer your portfolio into our Transact Discretionary Fund Management service 

It goes without saying that you must seek professional advice before making any changes to your portfolio. You know it makes sense*.

* The contents of this blog are for information purposes only and do not constitute individual advice. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. All information contained in this article is based on our current understanding of taxation, legislation and regulations in the current tax year. Any levels and bases of and reliefs from taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future. Although endeavours have been made to provide accurate and timely information, we cannot guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future.