What is risk? – Equities

By Peter Brooke
This article is published on: 12th June 2013

In this series of articles we are considering the different TYPES of RISK we take when investing in different assets. This should help to build a portfolio in which we fully understand what risks each part of the portfolio expose us to.

What are equities? – known  as stocks or shares they are a ‘share’ in a company. As a part owner of that company we must therefore SHARE in its profits (and losses). If the company goes bust we cannot expect not to share in this and lose (normally) everything we put in! Likewise if it is very profitable then we would hope to be rewarded as owners should be (by dividend or share price growth… or both); the performance of shares is well documented and on average they outperform most other assets over the long term but do we really understand all of the different types of RISK we take as investors in shares?

Asset risk – if equities themselves, as an asset class, are out of favour then they tend to all fall together if concerns about future growth (and therefore profits) are prevalent, this can be irrelevant of the market or sector you are looking at, which may have robust fundamental reasons to invest in it but is still knocked by the market selling off all equities.

Market or Correlation risk – many major stock markets are very highly correlated, so even if you have a diverse portfolio of European, US and UK stocks, for example, you can lose on all of them if they are highly correlated.

Sector Risk – companies all do different things, provide different services and make different goods, but sometimes a whole sector will be out of favour so losing value in what is a good company may still happen if the sector it is in is not loved.

Company specific risk – this is primarily down to the quality of the board of the company and the vast majority of company directors want their companies to do well; but their share price can also be affected by regulatory changes, legal actions, competitors, patents etc. no matter how good a company may be it is not bullet proof and so different companies will perform better in different parts of the market cycle.

Liquidity Risk – if you decide to buy smaller companies which aren’t very well known then there may be a minimal ‘market’ for them… this means that if you can’t find a buyer then you either can’t sell them at all, or you accept a lower price. Most shares are traded on regulated stock exchanges and so liquidity of all but the smallest companies tends to be good.

‘Shares are the only things we don’t buy on sale’ so all of the above risks, like with most assets, can create buying opportunities. It is often best to access shares via funds as the daily choices and control are managed by a professional manager, you can then also access many different sectors and markets with relatively small portfolios.

It is vital to understand the different types of risk so your overall asset base is not over exposed to one type of risk. For example someone with a large property portfolio (liquidity risk) shouldn’t then invest in small companies but should have more money in cash (inflation risk), high quality bonds (interest rate risk) and ‘blue chip’ shares (market risk).

This article is for information only and should not be considered as advice.

What is risk? – Bonds

By Peter Brooke
This article is published on: 23rd April 2013

In this series of articles we are considering the different TYPES of RISK we take when investing in different assets. This should help to build a portfolio in which we fully understand what risks each part of the portfolio expose us to.

The term bond is broadly used in the financial industry; here we concentrate on the “investment asset” often known as fixed interest, fixed income or debt securities. Government Bonds have their own specific names too; e.g. UK GILTS, US T-Bills & German BUNDS.

If a company or government needs to raise money and doesn’t want to (or can’t) issue new shares or borrow from a bank they may issue a bond. It promises to repay the bond holder its face value on a set date in the future and until then will pay interest for the loan (the coupon). Bonds are issued on the ‘issue date’ but can be freely traded on the bond market so their price can fluctuate with normal market conditions. The fluctuation in price means that the ‘yield’ changes too – this is the fixed coupon but if bought at a different price gives a different actual yield.

When a company is wound up (e.g. on bankruptcy) the bond holders, as creditors, are repaid from the assets of the company before shareholders; this means that bonds are considered safer to hold than shares. The coupon must also be paid before any dividends. So what risks should we consider before buying bonds:

Default Risk – can the bond issuer repay me my coupon every year AND can they pay me back at the end of the term?

Interest rate risk – as rates go up, bond values fall (and vice versa). In a low interest rate environment are we exposing the value of our capital to risk if interest rates are increased?

Market risk – these are investments, and though considered safe a flow of money out of the bond markets because of lack of confidence can affect prices.

Issuer specific risk – a lack of confidence in the future of the company can, like shares, create a selling of the bonds too.

Liquidity risk – if buying smaller company or peripheral government bonds, it can be tricky to sell them should you need to quickly.

SAFETY vs RISK – at the moment developed government and many ‘blue chip’ company bonds are trading at record low yields, and though they are considered SAFE (as they are unlikely to default) this doesn’t mean they are without RISK. If a bond has a yield of 1.5% and interest rates go up by 1% it is possible to lose 10% of the capital value… this is now not LOW RISK.

Buying bonds through a fund can often help reduce many risks; the manager can choose which sectors to invest in or not and can manage the specific risks appropriately. We favour global strategic bond funds as they have a very broad remit and a very large bond universe to invest into.

This article is for information only and should not be considered as advice.

What is risk? – Bank accounts and Cash

By Peter Brooke
This article is published on: 12th March 2013

RISK:  The dictionary definition: exposure to the chance of injury or loss; a hazard or dangerous chance.

We all think the concept of LOSS as being the principle financial risk, but there are different types of risk which can affect the value of our capital and the return we get from it;

The safest form of investment asset is considered to be CASH, but what are the risks (OF LOSS) if I hold €100 000 in my French bank account?

1. 1.    Counterparty & Jurisdictional Risk – If my bank (my counterparty) goes bust the French (my jurisdiction) government will currently underwrite the first €80 000 of all individual deposits –  a potential 20% counterparty risk in having this much money on my account. If I bank with a big name in a well protected jurisdiction I should be ok, but should I move the excess to another bank to reduce risk?
2. 2.    Inflation Risk – with time the COSTs of goods and services tend to increase; this eats away at the real value of money or ‘it’s buying power’. Today global inflation is approximately 2.5%p.a.

But that’s not the whole story as inflation is based on an average ’basket of goods and services’. At different stages of our lives the inflation of different elements within the ‘basket’ can vary: The cost of living might drop for a family with a mortgage when interest rates fall, but an elderly couple with food and fuel bills, and no mortgage feels the pinch as oil, coal and food prices rise.

1. 3.    Interest rate risk – the bank pays me interest on my money and lends it out at a higher rate and pockets the difference as profit. If interest rates are high I am taking risk that my return may  fall; can I get a similar return for similar risk elsewhere?

If interest rates are low, like today, then I am swapping interest rate risk for  inflation risk by having my money on account. It is therefore the amount of my return OVER INFLATION which should be my only concern when looking at the amount of risk I am willing to take.

Today if I am lucky enough to earn 0.5% interest it means I am losing 2% per year…. guaranteed.

1. 4.    Default risk – the bank should continue to pay me the interest as it receives it from its lenders. There is a small risk here if I choose a weaker bank.

But by banking my money I am NOT taking the following risks:

1. Liquidity risk – I can get to my money anytime.
2. Investment risk (volatility of returns) – my money is just in a bank account, the interest may change a tiny amount but the capital value remains stable (except for inflation).
3. Opportunity risk – as my money is not tied up I can use it to buy any sudden opportunities that come along (once I understand the risk/return swap).

This article is for information only and should not be considered as advice.