When we’re designing an investment portfolio for our clients, we take into account quite a number of considerations. We start by understanding your investment goals and time horizons, and then we build a full understanding of your liquidity requirements, any asset class preferences that you might have and also the returns that you expect.
This final element brings the whole area of risk into the discussion – what your appetite is for risk and also your capacity to withstand any shocks within your portfolio. We look to build a portfolio for you that, in an overall sense, reflects this appetite and capacity for risk. We want you to achieve your investment objectives, while at the same time ensuring you can get a good night’s sleep and not lie awake worrying about your investments. We’re firm believers that if you have an effective, risk-appropriate portfolio in place with a long term perspective, you can then filter out the noise caused by short term events, such as the recent volatility in markets.
We’re asked a lot about risk in an overall sense and also more specifically about the different types of risk and how they might impact your portfolio. So we thought it would be useful to set out some of the main risks that can have an impact on an investment portfolio.
However we want to start with a note of caution. This is not an exhaustive list; it is simply a list of the main risks. Please note that the magnitude and impact of risks change all of the time too, as investment conditions change. Of course we’re always happy to answer any specific questions that you have in relation to any of these risks.
This is certainly one of the most recognised risks. When there is a major economic shift, this can have quite a significant impact on investment portfolios. The last time we saw one of these was in 2008 / 2009 when the near-collapse of the banking industry plunged the world into recession, having a significant impact on investment portfolios around the world.
These are politically led events that happen across the world that create risks, which sometimes don’t play out as expected. For example when President Trump was elected, many commentators thought that this would herald a swift decline in investment portfolios. However the opposite turned out to be the case – the S&P 500 index was up 21% in the year after he was elected! But sometimes markets move more as expected – there was a 30% fall in markets (followed by a sharp recovery) after the Covid-19 pandemic hit and we also saw a 20% fall in markets in the year after Russia started the war in Ukraine.
This is where individual shares can be dragged down as a result of a significant market downturn in their sector, as opposed to issues that may be affecting the individual company itself. Probably better known as collateral damage!
This risk is impacted by changes within a single country or region. The value of a currency will be impacted by economic events that are specific to that country (along with other factors). So while the investment performance of (let’s say) British stocks that you hold may perform in line with expectations, the value of Sterling will have an impact on your investment too, either increasing or reducing the value when transferring the money back into Euros.
Interest Rate Risks
We all became very accustomed to an extremely low interest rate environment over the last decade, but nothing lasts forever. We have seen rates increasing sharply as central banks fight inflation and how this impacts different asset classes. For example, as interest rates rise, the yield on existing bonds falls, as investors will get a higher return from new bonds issued. Fixed interest (bond) fund managers in particular watch interest rates like a hawk. In the same vein, inflation risk is another that is carefully monitored by fixed interest fund managers in particular, but is of interest to every single person today!
Bonds are effectively loans made by investors to issuers (governments or companies usually) in return for a coupon each year and repayment of the loan (investment) at the end of the term. There is always a risk, sometimes very small and at other times bigger that the issuer will default on the repayment of the loan. Higher risk issuers have to pay a higher coupon (rate of return) to attract money to make this risk attractive to an investor.
As stated earlier, this is not an exhaustive list of risks. We all face risks every day in relation to every aspect of our lives, managing investments is no different. However the critical lesson is to be clear about your appetite and capacity for risk, and to ensure that your portfolio reflects this. Then you can leave the fund management experts to worry about all of these individual risks, as they seek to achieve the returns you expect in order to meet your investment goals and objectives.