Risk: What you need to know when building a portfolio
Hargreaves Lansdown’s Danny Cox says risk is more about investments not living up to expectations than how high the chance is of losing everything.
By Mark Smith, Senior reporter
Wednesday June 20, 2012
Risk is one of the fundamental considerations of finance and is central to the process of building any portfolio.
While regulatory bodies such as the FSA aim to protect investors from taking on more risk than they can afford, recent events such as the 2008 financial crisis and the ongoing eurozone problems emphasise critical flaws with the concept: risk is nearly impossible to determine, almost completely subjective and open to sudden and unpredictable changes.
"Risk is in the eye of the beholder," said Hargreaves Lansdown’s Danny Cox. "Risk can be understood as the possibility of not getting back your initial investment, and that is it at its most catastrophic, but in general terms it is best to understand risk as the chance of your investments not living up to expectations."
"The last five years have taught us that regardless of how diversified your investments, all assets can fall together. Equities fell more than 40 per cent following the collapse of Lehman Brothers and bonds didn’t fare much better."
Most investors understand that the greater the amount of risk that they are willing to take on, the greater the potential return.
However, even this simple principle is coming under threat as the world struggles to come to terms with the vast levels of debt held by the likes of Greece, Portugal and Ireland.
Data from FE Analytics
shows that the average Global Emerging Market fund, a relatively high-risk investment, has provided an annualised return of 6.2 per cent over the last 15 years compared with 4.64 per cent
from the average Sterling Corporate Bond fund.
Annualised returns of sectors over 15-yrs
|IMA Global Emerging Markets
|IMA UK Equity Income
|IMA UK Gilt
|IMA Sterling Corporate Bond
|IMA UK All Companies
Source: FE Analytics
One of the FSA’s requirements is that IFAs fill out an attitude-to-risk questionnaire with their clients before they can recommend any investments.
"Risk-profiling tools plug investors into a whole set of different parameters to come out with an answer but the trouble is that this isn’t the final stage. Risk is all about perception," explained Cox.
He says that risk questionnaires attempt to quantify into a simple number what is an intellectually unquantifiable concept.
"Attitude to risk can be split into three broad subdivisions," he added. "An investors’ capacity for risk – how much they can physically afford to lose without impacting their lifestyle, their risk tolerance – this is fairly subjective and asks how much loss are investors willing to see in their portfolio at any given time, and finally, how much risk is required for them to realise their investment goals."
"When you combine these then you can run into some problems when they don’t add up. An investor might need to put their money into higher-risk equities to reach a given goal but actually isn’t willing to see a 20 per cent loss on their investments, for instance."
Even when investors have decided on a set of investments that fit their attitude to risk, these are subject to change in the wider economy, while their profile is subject to changes in their own personal circumstances and other external factors.
Share prices fluctuate, interest rates vary and inflation is a risk too. Investors who haven’t recently revisited their attitude to risk could discover that they are being too cautious.
"Nobody knows how long the problems in the economy are going to run for," says Cox. "The eurozone crisis might be resolved tomorrow or it could be another four years. We recommend investors take a long-term view and spread themselves across as many risks as possible."
"If they don’t want to take risk, then leave their capital in cash and accept that they will lose money versus inflation."