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How to balance risk and reward when investing in financial markets

November 2017


Tags: Investing Strategies

One of the biggest questions you must ask yourself before deciding to invest in the financial markets is:

Is the investment worth the risk? Any investment in a company brings some element of risk with it, but the level of risk will typically depend on its country or industry of operation, the quality of the staff and management, and the soundness of its finances. Investors, therefore, should target a reasonable rate of return to match the risks they are running when they entrust their hard-earned cash to a company.

Our video questions just how risky investing is compared to other ways of spending money.

However, not taking enough investment risk can mean that your savings do not grow in line with inflation and you can stand to lose money in real terms over time. Assuming an inflation rate of 2%, an investment of £1,000 would be worth the equivalent of just £667 over 20 years.

 

Targeted returns

Total shareholder return is generated either through dividend payments or capital gains, or a combination of the two. Being aware of the risks you are taking to benefit from the shareholder distribution or share price increase is vital.

The best way of identifying a suitable risk/reward profile is to look at the asset classes open to investors and to rate how relatively secure, or dangerous, they are. The table below provides a framework for how you might go about this, although this is not meant to be prescriptive and should be tailored to your own attitude towards risk and reward.

Risk/reward profile for different assets

 

Risk (1-5, with 1 being the least risky and 5 being the most risky)

Required annual return

Government bonds (risk-free rate)

1

3%

Corporate bonds

2

4%-5%

Equities

3

10%

Small cap equities

4

30%

Biotech/natural resource explorers

5

50%+

Source: Shares Magazine

The calculation for this is based upon the yield of a Government bond. In principle this is risk-free and as a result is sometimes described as the ‘risk-free rate’. The Government will return your initial investment, or principal, upon maturity of the debt and in the meantime pay you interest in the form of coupons. Failure to do so is known as a default and is very rare. Britain has not failed to pay its creditors since the Stop of Exchequer under Charles II in 1672, not least because the Bank of England can always print money if it needs to.

 

 

Key risks

Drilling down a bit further, there are three key risks associated with any company or investment:

 

Market risks

These fall outside of management’s control, such as interest rates rises, inflation and general economic conditions, or even a stock market crash.

 

Company risks

These are issues specific to the sector or individual firm. The issues to address here include competition for market share, pricing, barriers to entry, management competence and financial strength.

 

Financial risk 

Debt is a killer. Interest payments suck away cash flow that could otherwise be invested in the core business to make it stronger and high debts mixed with weak cash flow can lead to disaster and bankruptcy in a worst case, and thus a nasty portfolio loss.

Your appetite for risk is yours to decide and yours alone. To assess just how much risk you are willing to take before investing your hard-earned cash there are four questions you need to answer:

  • Why am I investing?
  • What is my time horizon?
  • What target return would I like to make?
  • What is my appetite for risk?

The answers to these questions will form a risk/reward profile for yourself and help you to assess what is a reasonable return from your portfolio strategy. They will also shape your preferences by asset class, sector and type of stock, according to the risk/reward profile.

As this checklist suggests, you must also consider your own temperament. Some people are temperamentally more inclined to take risk and will find stock market volatility easier to take. Others may lie awake at night worrying about small losses to their capital.

 

Changing risks

One final – and more complex - concept to grasp is that the risk of different assets will vary over time. For example, if the stock market has risen a long way, prices are higher and therefore it will be riskier to invest. If the stock market has fallen a long way, prices are lower and it will therefore be less risky to invest. This can be counter-intuitive because stock markets will often fall after a period of economic decline, just as investors are least inclined to take risk.

All these factors will feed into the construction of an investment portfolio. For example, those investors who are risk averse and/or only have a short time to invest are more likely to hold part of their portfolios in bonds or cash, while those who are comfortable with fluctuations in the value of their investment, or have a longer time to invest are likely to hold more in the stock market.

There are ways to improve the risk/reward balance of a portfolio. The first is to diversify by holding a range of assets. While it would be handy to know which asset class was likely to perform best in any given year – bonds, equities or property, for example – it is difficult to predict. Holding a blend of asset classes reduces exposure to weakness in one particular area and can reduce risk. 

Also, investors need to consider the effect of compounding. Using a dividend to buy shares in the fund or individual company which has issued it, you can steadily increase your holdings and set yourself up for even more dividends down the line. These can also be reinvested, creating a virtuous circle of steadily increasing returns.

This has a powerful effect over time. It also means that investors are usually better off staying invested through the market ups and downs rather than trying to exit their investments at times of market turmoil and then reinvest at a better time. As the saying goes ‘time in the market is more important than timing the market’.

It also means that income is an investors’ friend. A consistent reliable income reinvested and compounded over time will go some way to giving investors more predictable returns. The definitive study of the returns from different asset classes is the Barclays Equity Gilt Study. It shows dividends were the most important factor in the stronger returns from the stock market over time. They should also give more risk-averse investors comfort that they are not simply taking a long-term bet on markets rising.

Learn more about fixed income

 

Jargon buster: Asset classes

An asset class is essentially a grouping of investments which have similar characteristics and tend to react similarly in different market conditions. The main asset classes are shares, bonds (that is the debt of governments and companies), cash, foreign currencies, property and commodities.

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Selftrade does not provide investment advice. This article is the authors view and is not the view or opinion of Selftrade and Selftrade accepts no liability for any loss caused as a result of the use of this information. The opinions expressed are those of the author at the time of writing and should not be interpreted as investment advice.

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