We all have different attitudes to risk. Some of us step through life with great care. We watch what we eat, we take regular exercise and look after our health and wellbeing.
On the opposite side of life, some of us live for the day. We eat whatever takes our fancy, we jump at the chance to ride the latest rollercoaster and get a kick from skiing down black runs.
The same mindsets also apply to investing.
Some of us will go out of our way to avoid risk. Why would we choose to put our hard-earned money into risky investments? Other people think nothing of buying bitcoin or chasing the next big thing in a bid to make a fortune, despite knowing they risk losing it all.
So, what is the best way to approach investment risk and how should you structure your portfolio to meet your own appetite for risk?
3 things to consider when measuring investment risk
- Volatility
This is a measure of how much the value of an investment moves up and down over time.
Investments whose values rise and fall frequently over time are considered to carry more risk. These figures can be useful, as they measure share price rises and falls, but it’s falling prices that people often worry about the most.
- Drawdowns
These measure peak-to-trough falls. This looks for the maximum drawdown, which indicates how much an investor could lose over a given period.
Companies regularly lose value and then bounce back, but if a company collapses, you lose any money you invested in the company for good.
- Liquidity
This measure of risk is often overlooked but focuses on how easily an investment can be sold or sold without accepting a discount to its market value.
Liquidity can disappear in times of crisis. For example, when measured by volatility or drawdown, property funds appear lower risk, but in 2016 and 2019, many of them closed in response to investor outflows and holders were left unable to sell them at all.
Different investments carry different risks
While using different risk measures can give different results, different assets also carry varying risk.
Cash
Cash is low risk. Your bank isn’t likely to collapse and, if it does, your savings are largely protected by the Financial Services Compensation Scheme. This government-backed insurance protects savings up to £85,000 for an individual account per financial institution, or £170,000 for joint accounts.
The single largest drawback of holding everything in cash is inflation, which, over time, can devalue what your money can buy.
Stocks and shares
Investing in company stocks and shares, or equities, is higher risk. Companies can collapse and their share price will always fluctuate depending on the success of the business, the economic environment and even investor behaviour.
Bonds
In terms of risk, bonds sit between equities and cash. People who own bonds in a company come ahead of shareholders. Bondholders receive interest payments and have their capital returned when the bond ends. However, if the company that issued the bond fails, bondholders still risk losing their money.
Risk levels also vary within asset classes. Generally, investing in emerging markets carries more risk than investing in developed markets. Also, corporate bonds tend to be riskier than government bonds.
Higher returns come with higher volatility
We don’t only consider how risky an activity is; we also consider the potential rewards. Skiing down a black run is a risk, but the thrill of doing it and reaching the bottom intact is a reward worthy of that risk. In fact, without the risk, we wouldn’t get the endorphin rush.
Likewise, when investing, it’s important to consider the potential rewards. How much money do you stand to make when you invest?
The chart below illustrates the returns from cash, bonds and equities over the last five years.
Equities have delivered the highest returns, while bonds and cash have returned lower results. The chart also clearly shows that higher returns come with higher volatility.
Remember, past performance is not an indication of future performance.
The chart clearly illustrates the higher rewards you can gain from investing in equities, but can you get the rewards and reduce the risk?
Reduce the risks without minimising your potential returns
If you are risk-averse, the best solution is to invest your money in lower-risk assets. But a portfolio full of cash and bonds will also lower your potential returns.
Therefore, you may be better off seeking risk-adjusted returns, where you aim to maximise returns you can achieve for your personal appetite for risk.
Diversify your holdings
One company can go bust, but it’s extremely unlikely that twenty companies will do so. Buy shares in a range of companies you expect to survive and some of these companies will thrive. Diversification can be achieved by investing in companies that span different regions, sectors and themes for example healthcare or technology.
If you invest in funds, this diversification is already built in.
Invest in different asset classes
Traditionally, it was standard practice to build portfolios using a combination of cash, bonds, and equities. But these days it’s possible to add alternative asset classes such as property or commodities.
Reducing the risk of volatility within a portfolio of investments can also help generate healthy returns, as excessive levels of volatility can impact your longer terms returns.
Naturally, higher risk doesn’t automatically translate into higher returns. All investments rise and fall in value and there’s always a risk that you won’t get back the amount you invested. Therefore, it’s important to ensure your investment portfolio is an accurate reflection of your own circumstances and your overall tolerance for risk.
Invest with a long-term view
Over the short term, equities have a higher risk of losing money. However, invest with a long-term view, and you’ll probably end up ahead. The longer the term you’re invested, the more likely this will be true. Over the last 100 years, the average equity market return is approximately 10% per annum.
Investment portfolios with high equity exposure have rarely lost money over a long-term period. Since we’re now working longer and living longer, we can also invest for longer.
Some risks are worth it
Many of us attempt to reduce risk as we progress through life, but we also recognise the benefits of taking a few risks. Changing jobs, getting married, or starting your own business can present a variety of risks, but the potential rewards drive us to move forward and make changes, despite the risk.
The same can also apply to investing. The short-term volatility from investing in assets can help generate greater rewards over the long term. This gives you access to long-term capital growth as well as the potential to benefit from the power of compound growth.
With careful planning, you can reduce your exposure to risk by spreading your investments across a variety of assets and sectors.
However, if you attempt to keep your money safe by holding everything in cash you expose savings to the greater risk of inflation. Just compare the cost of a loaf of bread 20 years ago (£0.52) with the price today (£1.06).
City A.M. recently discussed the issues surrounding inflation on cash savings, explaining how investing in funds gives people a better opportunity to beat inflation.
Our investment process means you have access to all our best investments, regardless of your attitude to risk.
All our clients have access to our best investment ideas, but the proportion your portfolio will hold in each idea will be determined by the level of risk to are willing and able to accept.
Get in touch
To find out more about how we can look after and grow your wealth, email us at enquiries@bowmoream.com or call 0203 617 9206.
The value of your investments can go down as well as up, so you could get back less than you invested.
Past performance is not a guide to future performance.
Bowmore Asset Management Ltd is authorised and regulated by the FCA
