What Are The Different Types Of Investment Risk?
Only yesterday I read an article in the Times about a couple who had lost everything through the negligent advice of their IFA. Nearly all their pension had been invested into one fund, which had been classed as high risk in nature. Yet this couple were 4 years from retirement and of a cautious risk profile. Unfortunately, negligent advice was all too common in the past, when some funds were “on trend” having produced good gains, but advisers understood very little about the risks of these funds and those investors lost money. Arguably, the industry has changed, and the investment world has, or should have, moved on now - portfolio planning is very much here to stay.
The adage “don’t put all of your eggs in one basket” should be all too familiar with the investor these days. From the boom to the bust periods, diversification serves as an all too important strategy to maximise returns and minimise loss – but do enough people really understand why this is necessary? Let’s take a look at investment risk in more detail:
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There are no low risk/high return investments – if an investment offered a disproportionately high return and was classed as a low risk asset, then the market would buy up these investments and artificially inflate the price to the point where the underlying asset was dangerously overpriced and no longer a ‘low risk’ investment as there is more likely to be a capital loss following a correction price fall from the overinflated purchase price
Guarantees – do they really exist? – an investment contract may state that it is “guaranteed” but read the small print. In the majority of cases the ‘guarantee’ is subject to certain conditions and criteria being met, not withstanding the fact that it may be a contractual guarantee based upon the financial strength of the investment company itself. Guarantees are an attractive feature and may provide low risk investors with peace of mind and a way of “dipping their toe” into the market, but make sure that you understand the terms and conditions in greater detail.
Systematic and non-systematic risk – spreading the risk of your investment across a portfolio of different assets can help to minimise losses and reduce the overall risk of the portfolio.
- Non-systematic risk - spreading your investment across 100 different industries/companies can help to diversify risk away (e.g. If there was a strike in a particular sector which impacted on company profits). This is what we call non-systematic risk, as this can be reduced by investing into more than one company, industry and across different stockmarkets/countries throughout the world.
- Systematic risk – you cannot avoid this type of risk, as it applies across the entire market as a whole. For example, changes in legislation, fiscal policy, terrorist attacks and political unrest.
What is ‘asset allocation’? – not all assets respond in the same way to news and events happening on a day to day basis:
- Equities, such as company shares and unit trust funds, tend to perform well during periods of economic growth, but fall in recession
- Bonds (Fixed Interest Securities) tend to outperform equities during recession, but prices fall as interest rates increase
An investor with a low risk profile may have over half of their portfolio invested in bonds and other low risk assets, which reflects their cautious attitude to risk; whilst a higher risk investor may want more of their portfolio invested in growth assets, such as equities.
Understanding investment risk is an essential part of the factfinding process, and only helps to strengthen the relationship between the adviser and client. Care should also be taken as to when the investor needs access to this money, and their ‘capacity for loss’. This means that if the adviser believes any losses incurred could cause serious financial hardship, the client will be guided into a risk profile more fitting to their overall circumstances, even if they class themselves as being ‘high risk’. Clearly this did not happen in the case of the couple mentioned earlier and these mistakes costed them dearly. So, if you have not had a risk profile review in the last few years, arrange a meeting with your adviser now, who shall be more than happy to discuss.
IFA & Pension Transfer Specialist
Circle Financial Services Limited