Addressing risk

Posted by Liz Rees in Latest insights category on 15 Aug 19

One of the reasons why Britain is a nation of savers rather than investors is because many people associate the stock market with a danger of losing money. However, there are different types of risk so this week we look at some ways to alleviate risk, and how it can also be rewarding.

Does risk equal danger?

In our personal lives, we tend to think of risk as something that might result in lasting impairment, such as jumping a red traffic light or engaging in extreme sports. When investing in funds, however, risk is usually measured in terms of volatility which is how much an asset fluctuates over time, rather than the possibility of losing your capital.

Although a supposedly low-risk cash account avoids stock markets fluctuations, it does expose you to inflation risk. In these times of ultra-low interest rates, this eats into purchasing power and in the last decade most cash ISAs have lost money in real terms (taking inflation into account). When investing, you need to take some risk to achieve higher returns. Regular investing, which averages out your purchase price, can be one way to smooth out market volatility.

Providing investors take a long-term approach, usually more than five years, the stock market has historically produced better returns than cash. Indeed, the latest Barclays Equity-Gilt Study found that UK shares returned an average 5.8% per annum in real terms over the last decade, compared to -2.5% p.a. for cash. Since records began in 1899, real returns were 4.9% p.a. and 0.7% p.a. respectively.

Getting to grips with risk

When investing, there are two personal risk factors to consider. The first is capacity for risk which depends on your time horizon and broader financial situation. If your goals are a long way off, then you have plenty of time to ride out greater volatility. Also, the more capital you have, the greater scope you have to take on some additional risk.

The second is your personal attitude to risk which is how much risk you feel comfortable with. Of course, there is no point in investing in the stock market if it keeps you awake at night, though this may be partly down to fear of the unknown. To achieve your financial goals you may need to balance a lack of confidence, with the potential risk of doing nothing.

There is plenty of guidance on the Willis Owen website that can help inexperienced investors make informed decisions and own their financial future. We’ve produced a short video on investing which helps put risk and reward in context and you can hone your investing skills with :play. If you still feel unsure, it may be worth consulting a financial adviser. Below are a few pointers to ensure you are not taking excessive risk:

Tip one: avoid the scammers

A recent survey of 2000 pension investors aged 45-65, published by the FCA (Financial Conduct Authority), revealed that 42% would be taken in by 6 common tactics used by scammers. These include: cold calls, free pension reviews, claims of guaranteed high returns, exotic investments, time-limited offers and early access to cash.

If we are so risk averse, why do many people fall victim to scammers? It boils down to trust; some fraudsters are very convincing and the promise of high returns and/or attractive income can be very tempting. Nearly a quarter of respondents were tempted by investments in overseas property, renewable energy bonds, forestry, storage units or biofuels. However, these are high-risk and unlikely to be suitable for pension savings.

The research also found that those who consider themselves smart or financially savvy are just as likely to be persuaded by these methods. The FCA is currently running a ScamSmart campaign on TV, radio and online- it is aimed at pension-holders but has a valuable message for all investors. There is useful guidance on how to avoid scams on their website.

Tip two: diversification

Individual investments carry different sorts and amounts of risk so having a well-diversified portfolio, including cash, is a sensible strategy. Your allocation to each asset class, such as bonds, shares, property and alternatives, should be a reflection of your attitude to, and capacity for, risk.

If you have a small amount to invest, or prefer a ‘hands off’ approach, a multi-asset fund may meet your needs, while for a larger portfolio you may want to do your own asset allocation. Most people have a bias towards their home country, yet diversifying overseas spreads risk because not all economies are at the same stage of development or in the economic cycle.

Furthermore, you can access different opportunities; for example, the US excels in technology, which accounts for around a quarter of the stock market. Not all themes perform well at the same time which brings to mind the saying ‘don’t put all your eggs in one basket’. Even a so-called ‘safe haven’ like gold is only safe until it isn’t!

Remember though that overseas investments expose you to currency risk; this has been beneficial in recent years due to the depreciation of sterling. Holding a global portfolio may balance out any risk over time but if you hold a strong view on the direction of a currency, some providers offer hedged share classes.

Tip three: let a fund take the strain

While sophisticated investors may opt for individual shares or bonds, there are funds to suit a range of risk appetites. Companies can, and do, sometimes become worthless, whereas funds hold a portfolio of assets so are unlikely to fail. Multi-asset funds, which take care of asset allocation across asset classes, geographies and styles, have lower volatility than specialist ones, such as those investing in mining stocks.

Whether you buy a passive or active fund will affect the type of risk you are taking. A passive fund limits you to the risk of the market index it tracks (this is called beta) so you won’t have the risk of underperforming the benchmark (other than by fees). On the other hand, an active fund delegates some aspects of risk-taking to fund managers, in the hope they can generate returns in excess of their benchmark (known as alpha).

The Willis Owen platform has tools to help you build a portfolio. For those taking the first steps, there are selected multi-asset or starter portfolios covering three risk groups while experienced investors can select individual funds using a range of filters in our :explore centre. Morningstar analyst ratings and reports may be useful but always read the KIID and factsheet before making a decision.

Tip four: understand and monitor

Stock markets are constantly evolving so it’s important to check your portfolio on a regular basis. Once a year you may wish to rebalance to match your risk profile, in response to market moves and any changes in your personal circumstances, but don’t be tempted to overtrade.

Asset classes perform differently depending on economic conditions, so you may want to take some profits in your winners and add to funds which have been left behind. However, try and understand the reasons for under-performance against a peer group or benchmark; has the manager left or has there been a change of strategy or is the style simply out of favour?

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.