Investment principles and risk

Our audiovisual presentation provides an introduction to the various types of risk that could...

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...e risk that the desired returns from an investment over time will fall short of their target

We looked at market (or systematic risk) and investment specific (or non-systematic risk) in chapter 4, and how risk is incorporated into different investment theories. These are summarised again below: 

“ Systematic ” risk will affect the performance of most or all securiti...

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... to counteract this type of risk is to hold a number of different stocks, shares or even asset types within a portfolio ( to 'diversify')

BP shares fell in value during 2010 in relation to the disaster in the Gulf of Mexico. What type of risk is this?

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This is the risk that inflation will reduce the purchasing power of an investment over a period of time. This is where the cost of living rises at a higher rate than investment returns, and simply means that something that costs £100 today may cost £115 in five years' time. Investments will need to increase at least in line with inflation in order to maintain the same standard of living. Where investments underperform inflation, this can mean a shortfall in real terms.

Costs of goods and services

Not all costs of goods and services increase at the same rate as inflation:

Earnings have historically risen faster than inflation. This is because workers generally expect to get some benefit from any increases in produc...

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...as wars or shortages, currency devaluation and high wage demands

Controlling inflation

During the economic crisis there was a real risk of deflation and the spectre of a recession as deep as the great depression in the 1930s. Governments around the world coordinated the deployment of fiscal stimulus packages, pumping money into the economy in an attempt to lessen the impact. The risk of doing this is that there is more money chasing fewer goods, leading to increased prices.

History has shown that the economy runs in cycles and inflation will periodically present a challenge for advisers and their clients.

Which are the two types of investment usually hardest hit by rising inflation?

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This is the effect of a fall or rise in interest rates on the level of income that may be provided by an investment. A rise in rates could be good for variable rate savers, but not good for borrowers. Likewise, a fall in rates will have the opposite effect. This risk could be managed by using fixed rates for saving and borrowin...

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...reduce short-term interest rates

Inflation expectations

Expectations of rising inflation will push up longer term interest rates, typically leading to a steeper yield curve

Liquidity

In uncertain times investors prefer to hold money in short-term securities, increasing demand and pushing down short term rates

Credit risk can also be referred to as default or provider risk, and it is the risk that an institution is unable to meet its financial obligations to investors and fails to pay capital or interest when it falls due. This is particularly important for investors in fixed interest securities and those who invest cash with financial institutions.

There are four different types of credit risk:

Default risk – this is based on the ability of the financial institution to meet all of its capital and/or interest obligations. Credit rating agencies provide ratings to help investors assess...

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...s and depositors. We first saw this in early 2013 when Cyprus Bank's bondholders and depositors with more than 100,000 euros in their accounts were forced to write-off a percentage of their holdings. Since then we have seen it again with the restructuring of the Co-op Bank.

The bail-in idea has been on the agenda of the Financial Stability Board; it is likely that it may be used in the future in the event of another financial crisis where the cost of help is met by the institution and not the Government.

What are the four main types of credit risk?

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Currency risk

Where investments are in overseas currencies or foreign assets, an appreciation of the pound can reduce the value of these investments to the portfolio. When sterling is strong against a foreign currency, any capital growth from investment in that currency can be lost and the value of dividends paid in the foreign currency is eroded.

For individual companies that depend on exporting goods a strong currency can seriously affect their profitability, as their goods will become more expensive to buy in foreign currency. It also means that the value of their overseas profits will be eroded when c...

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... their risk and return objectives. Operational risks are those that arise from the investment process itself, and include:

Settlement or counterparty risk – the counterparty to a transaction may fail to settle (consider the effect of the failure of Lehman Brothers in 2008)

Fraud – this can be internal or external including the misappropriation of funds

Misrepresentation - misleading reports and valuations

Systems failure

Trading errors and unauthorised trading

Staff errors

Regulatory risk

What do operational risks relate to?

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There is no investment that is entirely risk free, Investment markets offer access to a wide range of risk levels, from the safest index-linked government gilt to highly speculative unlisted shares. Investments with higher risk usually have the potential for higher returns. The volatility of an investment can be measured by looking at the highest and lowest price of a share or investment over a period of time.

It is generally accepted that diversification of a...

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...longed spells of warm and dry weather. On the other hand, makers of umbrellas will benefit from increased sales where there are periods of wet weather.

No Correlation - Returns from some companies are not related in any way to others. For example an English firm making furniture for the domestic market will not be correlated with a South African gold mining firm.

How does diversification address risk in a portfolio?

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Gearing, or leverage, is the impact of borrowing on the potential profits or losses of a portfolio. Where money is borrowed against the assets of a portfolio with the objective of increasing exposure to other assets, this can have the effect of magnifying both the positive and negative returns.

Example

Natalie is convinced that shares in ABC Ltd are going to rise strongly and she wishes to maximise her exposure. Sh...

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...e return (£7,000 - £10,000)/£10,000 x 100= -30%

The actual return on Natalie’s investment is therefore -30% compared with an increase in the share price of -20%

There are likely to be additional costs, such as the cost of borrowing and interest payable, which have not been taken into account in this example.

What affect would gearing have on losses?

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Your results and the estimated s...

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...ate.

Estimated study time 2.3 hours