In everyday life people approach risk in many different ways. Some of us choose to eat healthy foods, work out regularly and stick to the speed limit. For others, skiing down black runs and jumping out of aeroplanes are sources of fun.
Those same mindsets can also be found in investment. Some people will avoid risk at all costs – after all, it’s their hard-earned money, why take chances with it? Others plunge their money into bitcoin or the latest internet sensation in an effort to make a fortune, at the same time running the risk of losing everything.
But what is the best way to approach investment risk, and how should this impact your portfolio?
What is risk?
Firstly, some definitions. There are a number of standard ways of measuring investment risk – chief among these are:
This is a statistical measure of how much the value of an investment moves up and down over time. In mathematical terms, this is the standard deviation – investments with a higher standard deviation are considered more risky.
Volatility figures are useful but carry a flaw – they measure both share price rises and falls, but it’s the latter most people worry about. To counter this we also look at drawdowns – peak to trough falls – and in particular the maximum drawdown – the largest such figure over a given time period. By focusing on downside risk this gives us an idea as to how much an investor could lose. A related concept is permanent loss of capital. Companies fall in value and then bounce back all the time, but if a company goes bust then 100% of your money is gone for good.
An often overlooked measure of risk is liquidity – how easily an investment can be sold, or at least sold without accepting a discount to its market value. Often this can disappear in times of crisis. Property funds appeared lower risk when measured by volatility or drawdowns, but in 2016 and 2019 many of them shut up shop in response to investor outflows and holders were unable to sell them at all.
Riskiness of different investments
Though using different risk measures gives different results, there are some general points we can make about the riskiness of different asset classes.
Cash is low risk. Your bank is unlikely to go bust, and even if it does your savings are largely backed by the Government under the Financial Services Compensation Scheme.
Equities are clearly higher risk. A company most definitely can go bust, and even if it doesn’t its share price will fluctuate depending on the success of the business, how supportive the economic environment is and even the whims of investors.
Bonds stand some way between equities and cash in terms of riskiness. Bondholders stand in front of shareholders when it comes to receiving interest payments and having their capital returned at the end of the bond’s life, but if the issuer goes out of business they can still lose their money.
The numbers back this up. In terms of both volatility and drawdowns, cash has been less risky than bonds, and bonds less risky than equities. Risk levels vary within asset classes as well – emerging market equities are typically riskier than developed market equities, whilst corporate bonds are generally riskier than government bonds (unless that government is Argentina!)
In life we don’t just consider how risky an activity is, we also look at the potential rewards. Similarly we need to look at the reward for owning an investment – how much money you can make.
Equity holders share in a company’s profits so returns are almost limitless – someone buying Amazon shares 20 years ago would have made more than 219x their initial investment*. Bondholders can make money if the bond rises in value, but their returns are primarily driven by interest payments. Cash returns are entirely driven by interest rates and are typically low.
Plotting risk against return for these asset classes in the chart below shows that, over the last five years, returns have followed that pattern. Equities have delivered high returns, bonds middling returns and cash low returns. But the chart also illustrates another point: those higher returns have come with higher volatility.
As always, remember that past performance is not an indication of future performance.
Of course higher risk assets can also deliver lower returns, otherwise they wouldn’t be risky, but generally, when investing over the long term, the two go hand in hand. So how do we go about reducing risk?
Lowering risk levels
The simplest way is to invest in lower-risk assets. A portfolio stuffed with cash and bonds is likely to deliver lower risk, but also lower returns. For this reason in investment we often talk about risk-adjusted returns, and look to maximise the returns we can achieve for a given level of risk.
There are two key strategies that can help you achieve this:
Diversify your holdings
One company can go bust, but twenty companies are extremely unlikely to. If you buy a range of companies most are likely to survive and some will thrive, particularly if you choose companies operating in different industries with different business models. Invest in funds and this diversification comes built in.
Invest in different asset classes
Historically standard practice was to build portfolios consisting of just cash, bonds and equities, but this is no longer the case. At Tilney we add spice to portfolios by using alternative asset classes such as infrastructure, gold and absolute return funds. In the right market conditions these can generate outstanding returns in their own right, but even if they don’t they can provide valuable diversification, reducing portfolio volatility levels and helping to generate strong risk-adjusted returns. Of course, higher risk doesn’t always mean higher returns – all investments go up and down in value and there’s always the risk that you may not get back the amount you invested. You should always ensure your portfolio suits your individual circumstances.
The risks of a low-risk approach
For more cautious investors, the combination of lower risk and lower returns might seem attractive. However, it comes with a problem: inflation can invisibly eat away at your returns. This is less of a problem for equities – companies faced with rising costs can often simply raise their prices, leaving their profits unaffected. However, with interest rates low, returns from bonds and particularly cash have also been low in recent years. And those lower returns can easily turn into negative returns once inflation has taken a bite.
So if supposedly lower-risk assets now carry very real risks, and equities are by definition high risk, how should we invest? One way is to change your definition of risk.
Equities do have a higher risk of losing money over the short term, but over the long term their strong returns mean you could end up ahead. And the longer the time period, the more likely this is.
The chart below illustrates this. Over one-year periods since 1970, developed market equities have generated returns of between -30.3% and 56.2% – clearly a gamble. However, over three and five-year periods the disparity starts to narrow – good years and bad years begin to cancel each other out. And over 10-year periods equities have almost always come good, with annualised returns varying from a lowly -1.0% to a stellar 23.7%. Of course future returns are not guaranteed and you could still lose money even over a 10-year period, but this has seldom happened over the last 51 years.
Put simply, portfolios with higher weights in equities have rarely lost money over long-time periods. And more and more of us can afford to invest with long term horizons. The parents of a new-born girl have eighteen years to save for her university education, but despite this the majority of Junior ISAs are left in cash. A man retiring at 65 can expect to live for another 19.9 years**. We’re working for longer and living longer, and that means we can invest for longer.
Of course, higher risk doesn’t always mean higher returns and you should always ensure your portfolio suits your individual circumstances. But by changing your approach to risk to be less concerned about short-term performance, you can increase your chances of generating better returns over the long term.
In everyday life we try to reduce risk, but we also recognise that some risky activities – changing job, proposing marriage, starting a business – can ultimately drive our success and happiness. The same is true in investment – riding out the shorter-term volatility associated with risky assets such as equities can help you generate better long-term capital growth for your portfolio.
There are ways to reduce the risk from equities – invest in high-quality companies, have a diversified portfolio, combine them with other asset classes. However, looking to avoid risk altogether can be counterproductive. Sometimes the biggest risk is taking no risk at all.
*Morningstar, 11 June 21.
**Source: Office for National Statistics, 25 June 2020.