The riskiness of an investment is typically judged by volatility, how much the price fluctuates up and down. However, risk is not always as simple as this, and investors need to focus on how an asset might perform in the bad times to get an understanding of how much risk they are trading.
What constitutes a bad outcome will vary from investor to investor. If an investor is saving for a pension or to pay off a mortgage, than a bad outcome would be considered a shortfall from the targeted return. This is different than the risk of a negative return. In these two examples, the reason for why the investor may become uncomfortable with the ‘risk’, and sell, are different :
- If pension investments look like they will not produce enough return to fund a comfortable retirement (for example less than a +5% return p.a.), the investor may consider selling their funds and placing their money elsewhere
- If an investor is speculating on the stock-market then any return above a negative one may be acceptable. They may only sell if their shares cross a certain loss threshold (for example more than a -5% loss)
In these two scenarios what the investor considers ‘risky’ is very different.
Risk can be categorised in two ways :
- The risk of failing to meet an objective i.s. not being enough to finance retirement
- The risk of a negative impact from the investment e.g. a financial loss.
Hence the pattern of investment to achieve an objective is very important. If an asset returns 5% every year, then there will be no fear of loss, or failure to achieve an objective. If an asset loses -15% one year, but returns 40% profit the next, it may still achieve the objective, however the investor may have sold their investment at the 15% loss due to the fear of loss.
It is important to know your objectives and your attitude to risk.
Attitude to risk is an assessment of how much risk you are willing to accept, or what risk would make you feel uncomfortable. Most financial advisers will go through an attitude to risk questionnaire, in order to find how much risk you would be willing to take. This might include questions such as :
- Have you ever invested in high risk assets before ?
- Would you prefer the chance of a 5% gain with no risk, or the chance of 20% gain with the risk of a 10% loss
Most funds come with a ‘risk score’, with categories such as :
- Very Cautions
- Very Adventurous
These categories normally relate to the types of asset. For example a bank savings account, or Government bonds, would be very cautions investments. Stock and shares in small-cap emerging countries, would be considered very adventurous. The volatility, and potential loss, relate to the risk level of the investment.
A financial advisor can mix various assets and funds together to create an overall risk profile, that matches your attitude to risk. This may contain some exposure to both low risk, and high risk assets, to give an overall balanced portfolio. It is important to regularly review your investments to ensure they stay inline with your attitude to risk, and are on track to meet your objectives.
Indeed diversification is one of the best ways to expose yourself to risk, whilst making the portfolio as a whole less risky. Investing in the shares of one technology company, is higher risk than investing in a large basket of companies from many different sectors and countries, even if each individual company has the same risk level.
The insights from behavioural finance on investor loss aversion are particularly important here. Disappointing performance disproportionately undermines investor confidence. Research shows investors attach different importance to achieving different goals. The risk of bad outcomes should first be reduced, for objectives that the investor sees as critical. For example not having a draw-down of more than -20% may be more important than not achieving an investment goal of £100,000 (or vice versa).
The second half of this video shows a fund manger explaining how they must diversify their portfolio to have returns from non-correlated markets, in order to reduce overall risk.