Common types of investment risk

The decisions we make today have to interact with the future before we know whether the correct decisions have been made; i.e. whether we have effectively managed investment risk to achieve the prospective returns available, or whether we have simply received the risk of investing.

As financial professionals, the most commonly used measure of investment risk is standard deviation, or a measurement of volatility. But one number will not completely measure all of the investment risk our clients face as investors. It is therefore important to remember that investment risk is subjective. I like to think of it as a moving target affected by a variety of factors and market pricing. It’s always useful to remember the types of risks inherent within different investments, which may not necessarily be reflected in historical volatility measurements. Here are a few of these risks that our investments are exposed to. 

Inflation risk

I expect inflation is one of the main reasons so many clients invest in the first place. Whilst keeping funds on deposit in the bank provides very high security of the return of your capital, it is still exposed to the threat of inflation, and in particular periods of high inflation. The low deposit returns available and the constant perceived threat of inflation, drive many every day people to become investors, often reluctantly. Whilst it would be obvious to suggest a great majority of the population would be better off with the combination of higher deposit rates and low inflation, leaving no requirement to invest in anything other than cash; this is a utopia whose prospects appear remote.

Capital risk

Every investment carries with it the worst risk of all; that you won’t get back your original investment capital. At the very basic level, a share in a company has a higher risk of outright capital loss than a bond, but for practical purposes, these types of risks have already been diversified away via fund management and indexing.

With a well-diversified multi asset portfolio that most financial advisers/planners would recommend, the likelihood of outright capital loss over a long-term horizon is so small that it is close to irrelevance, however when we introduce real world client timescales for investment it remains an essential part of our investment planning.

A 50-year historical chart will show that you don’t really have much to worry about when investing and can sit back patiently and ignore all the swings, rhetoric and analysis. But this misses a crucial point – How many of your clients truly have this level of time horizon?

We all understand the long-term benefits of investing, yet clients have both short-term mindsets and medium-term needs making capital risk a very real concern.

Interest rate risk

The rate of interest plays a particularly crucial role in determining the price of bonds, and therefore indirectly the price of every other asset. When the Bank of England base rate is 0.5%, it explains a great part of why we see 15-year government bond yields at 1.38%. When the Bank of England base rate is 3% for example, bonds will be providing a yield that is too low and the reason is simple. If you can obtain a yield of 3% from a Bank deposit, why would you accept the risk of capital loss for an investment yielding anything less than this?

Thus you can conclude that the interest rate acts like gravity on prices when they rise, and a pump on prices when they decline. The simple inverse relationship, as follows:

Liquidity

The importance of liquidity is usually underestimated until it is needed. Whist liquidity isn’t such an important issue for large endowments and pension funds with very long timespans and measurable cash flow needs, I feel it is a crucial factor for everyday investors because they are more dependent on their investment assets for their financial and lifestyle needs (many of which are unpredictable in nature).

Owning a portfolio of securities that have a large market demand and traded daily is far more liquid than owning one property that can take years to find the right buyer, and months to complete the sale. With liquidity comes the possibility that you may have to accept a price you do not want, but at least you can accept some price. If you have a truly illiquid investment you can find yourselves unable to obtain any cash for your asset, at least not when you need it. This can further exacerbate any financial difficulties an individual may be experiencing.

Currency risk

If you invest outside of the UK, you expose yourself to currency risk, i.e. the underlying investment asset may nominally perform well in its domestic currency, but the return you receive in sterling is eroded by currency fluctuations (i.e. the pound strengthens agains the investment currency).

On this subject it is also worth mentioning that having your finances entirely in one currency also means that you are taking some element of currency risk which is less clear to most investors (but especially important in times of extreme upheaval). For example, if you have all your assets in a currency that becomes worth considerably less compared to other currencies, then you will have lost a considerable amount of your real world purchasing power. This would more properly be classified as high inflation risk, but I feel it would be wrong to conclude that having all of your finances exposed to only one currency removes currency risk entirely from your finances and is a lower risk strategy than allocating your finances with a global mindset. If all your expenses are in one particular currency however, currency risk becomes particularly acute, especially if you do not have much of a margin for error.

Leverage risk

Using leverage to fuel investments is in my view, a little like an athlete taking performance-enhancing drugs – I regard it as akin to financial cheating. I understand why leverage is so popular, but at best it is dangerous.

If you only have savings of say £10,000, it’s rather tempting to borrow £90,000 and then invest £100,000 into a property, than it is to only invest with the £10,000 that you have. If you obtain a 10% return on £10,000, you only gain £1,000. However if you obtain a 10% return on £100,000, you gain £10,000, therefore doubling your initial investment. However leverage not only magnifies gains, it magnifies losses.

A 10% decline on your £10,000 investment still leaves you with £9,000 of capital. A 10% decline on your leveraged £100,000, essentially wipes out all of your capital. Leverage appears to work like magic when it goes in your favour, but when it goes against you the consequences are disastrous. The risk of leverage becomes particularly severe when combined with some of the other risks mentioned, such as illiquidity, rising interest rates and currency fluctuations. Despite history showing us many examples of over-leveraging causing financial chaos, the attractiveness of magnifying (and speeding up) investment gains suggest that we are likely to repeat the same mistakes.

More than a number

The use of standard deviation to measure volatility (which has then become defined as risk) does not represent the true picture of risk when investing. However, while it is important to understand its limitations, there isn’t a single measure that is better than it. Rather, in my view, it is important to think of risk as an overall concept with a variety of factors. This list of some investment risks is not an exhaustive list of range of risk we face, but I hope it is enough to illustrate that risk means more than just a number.