Controlling investment risk

Published by Lee Hayward on 5 October 2020

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Perhaps the best place to start here is to understand exactly what is meant by ‘risk’.

Risk is the chance that you might not get the returns that you wanted, needed, or expected. It is generally regarded as the chance of incurring a loss.

One individual’s perception of risk can be quite different to another individual’s, which may be different again to what the investment industry portrays as risk. It is therefore important for advisers to help their clients understand the nature of investment risk in addition to carefully assessing each client’s individual risk profile.

Many financial advisory firms will use risk profiling tools with their clients, but these should not be the decisive factor when determining a specific client’s attitude to risk. They should instead be used as part of a wider conversation that digs a little deeper to ensure the suitability of a particular outcome.

The risk assessment process dovetails with an assessment of the clients Capacity for Loss. A client might have vast amounts of wealth but no appetite for risk. Conversely, a client down to their last few pounds might be willing to place it all on red!

Investment risks can be many and varied. They could encompass inflationary risks, where an investment fails to beat inflation; they could be shortfall risks, where an investor fails to achieve an objective because they either haven’t taken sufficient risk for their investment to grow, or they have taken too much risk and seen their investment lose value at the wrong time.

The economy and politics both create investment risks. The economy factors in growth, inflation, sentiment, employment and interest rates. Whilst political risk involves changes in government, and national and international issues.

And then there is market risk, where asset classes are affected by factors which see whole markets decline at the same time, the 2008 Global Financial Crisis being a relatively recent example of this.

Beyond these there are a plethora of other risks ranging from credit and currency risks, to sector and volatility risks.

In the world of investments, there are many formulas that can be used to compare risks associated with different funds. For example one method, Standard Deviation measures the variability of (daily) returns.

So how do we attempt to mitigate these risks when constructing an investment portfolio for a client?

Diversification is a keyword here. Diversification of investment types (equities, bonds etc.), geographies (countries, markets), and themes (identifying the trends likely to influence markets over a selected period i.e. climate change, growing populations, limited resources, and dare I mention pandemics!

We might employ currency hedging strategies to reduce the risk of loss caused by exchange rate fluctuations, and derivatives for defensive portfolio management.

We may include guaranteed investments to protect capital, and Absolute Return funds which are designed to deliver positive returns in any market conditions.

We select funds that are not overly correlated to one another, and every fund in the portfolio is chosen with particular objectives in mind.

We will structure the portfolio in such a way that a portion of it is focussed on downside protection, squeezing out market volatility, whilst another portion will focus on the growth opportunities that we see in the market. The extent to which the portfolio is weighted towards defensive funds or growth funds is determined by the risk profile agreed with the individual client.

Our service proposition at Kreston Reeves Financial Planning, includes a Discretionary management option for clients who wish to place their trust in our investment process and expertise. Discretionary portfolios are adjusted to reflect our views of the market, the threats and opportunities that it presents, without the need to seek client approval before initiating any changes. In this way, the portfolio maintains its alignment with our interpretation of the markets throughout the year.

Clients receive periodic reviews to discuss among other things, their objectives and aspirations, and to cover the performance and risk profile of their investments. This regular contact helps to maintain an accurate understanding of their appetite for risk, and their capacity for loss. Adjustments can then be applied where necessary.

It can be all too easy to focus on performance, and either criticise something that appears to be ‘below par’ or praise something that at first glance appears highly impressive. In our view, it is about understanding the risks being taken behind those headline numbers. What level of risk has been taken to achieve that performance, and does it fit with the client’s appetite for risk and capacity for loss? Is the client even aware of the risks being taken with their money? Return per unit of risk is often a better way of determining how successful an investment has been, and we have a strong focus on this risk/reward outcome as part of our investment process.

The adviser/client relationship is a partnership based on trust, and we consider that our risk control measures are a key component of our investment proposition, and a fundamental reason why so many of our clients remain invested with us over the long term.

Remember that if a return looks too good to be true, there may be a risk that you are not seeing!

If you would like to discuss investing, existing investments or the underlying investments within a pension or ISA, please contact our Financial Planning team on +44 (0)1227 768231 or provide your details on our online enquiry form.

The content of this article is for information only and does not constitute formal financial advice.

This material is for general information only and does not constitute investment, tax, legal or other forms of advice. You should not rely on this information to make, or refrain from making any decisions. Always obtain independent, professional advice for your own particular situation.

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