Inv- Risk 1- Ian McKeever & Co.

When it comes to investment everyone talks about investment returns. There is almost always some fund that had you invested in it five years ago, would have tripled your money. There is also always somebody ready to tell you which fund it was. The unspoken assumption is that if you invest in it now you will triple your investment. Unfortunately it doesn’t work that way.

There is also generally a fund that would have halved your money over the same period, but you are not told about that one. Over the next five years it might actually be a better bet but in practice you do not know and nor does anyone else.

As recent events have proved all investment is about risk as well as reward. Even money in a deposit account is at risk if the bank fails. However there are various kinds of risk and it is important to know what kinds of risk are important to you if only so that you understand what it is you are trying to avoid.

Share prices at any given time are partly based on fundamentals such as past performance and future expectations but to a very significant extent they are determined by emotion. The emotions are greed and fear. That is true for professional investors as well as amateurs.

All investment is about risk and reward, fear and greed. If you seek higher returns that almost always mean accepting risk, and accepting risk means that sometimes you will lose money on some of your investments.

There are very few fundamentally bad investments. There is a price at which most investments are good value, and a price at which they are bad value. The difference between a good investment and a bad investment is generally ultimately a matter of price. This means does the market price underprice or overprice the risk? Risk is not therefore just something to be avoided. Risk and pricing risk is central to the investment process.

A lot is made of how much risk is associated with particular investments. However if you feel that making a loss on any of your investments is unacceptable, the advice must be you make only risk free investments. Even if that is the case you still need to understand the different kinds of risk if only so that you can avoid those that are important to you.

If you believe that taking risks will eventually lead to higher returns overall you must accept that some of your individual investments will lose money. In that case you not only need to understand the various kinds of risk, you also need to consider how you might control those risks.

The Kinds of Risk
One automatically thinks of risk as being risk to capital but there is another risk and that is risk to income. They are each important to someone but which is most important to you depends on your circumstances.

Inflation is another kind of risk that affects both capital and income. Protecting the monetary value of your investment may benefit you very little, if money itself loses its value.

For a young person saving up to buy a house or start a business, capital security is all that matters. If interest rates fall by half, maybe it will take you slightly longer to reach your goal, but it is not a complete disaster. If your savings halved in value it would be.

For the young person the minimum risk investment is a Post Office deposit account because that has a government guarantee and the capital is protected. The targets are short term and therefore unless inflation becomes rampant it does not constitute a great risk.

That is not to say that inflation is not risk for a young person with short term objectives just that at worst it means that after tax the interest on the deposit account may not compensate for the fall in the purchasing power of the savings already made. That decline is probably small and not disastrous and is more than made up for by the flexibility of easy access.

If inflation is a serious problem index linked savings certificates will solve the problem. If there is too much money involved for the Saving Certificate solution short index linked gilts are an alternative.

On the other hand imagine you are a seventy-year-old pensioner living in the interest from a deposit account paying 6%. Here the risks are much more complex and need to be looked at individually.

Income Risk
Everything looks fine until interest rates fall to 3%. The only way the pensioner can maintain his standard of living is eat into the capital at an ever-faster rate. The more capital he spends the less interest is earned and so the faster he needs to spend capital. Ignoring inflation the capital will be exhausted in just over 23 years. Assuming he is healthy that is just about his life expectancy. It is a matter of chance whether his life runs out before your money does. This is a disaster, which puts a completely different slant on the phrase “Your money or your life?

For the pensioner the way to avoid this risk is to invest in a long gilt such a 4¼% 2055. If interest rates double the capital value of the holding might halve but the income will come in at the same level for the rest of the pensioner’s life.

Inflation risk.
If he wanted to protect the purchasing power of his income he would need to invest in long Index Linked Gilts rather than conventional ones that way the coupon (interest) would keep pace with inflation.

Capital Risk
The pensioner himself has some capital risk. He may find that he has dry rot in the house and expensive restoration work is required. If he has to sell these Gilts there is no guarantee that he will get his money back if interest rates rise and prices fall. However his primary risk is income risk and this will hopefully only affect a small proportion of hi capital.

If he wants to leave his money to his grandchildren there is a more serious capital risk for them. The price of the very longest index linked Gilts is highly dependant on real interest rates in the market. If real interest rates rose from say 1½% a yield seem recently to 4% a yield seen in the ERM crisis when John Major was prime Minister) the stock could lose half its value. However, clearly there are limits to the capital risk and the granchildren must take the place in the universe of risk.

However this does highlight one important aspect of risk. If you protect against income risk you have to accept capital risk. If you protect against capital risk you have to accept income risk. There is no way to protect against both.

The cost of Certainty
If you deposit your money with a less risky institution the yield falls. If you invest in conventional gilts as opposed to deposits it will affect yields one way or another. If you want inflsation protection income yields fall again.

In the case of our pensioner he might eleminate all his income and inflation risks but his income might fall from say 6% to say 2% or even 1%. He may simply have have substituted the risk of penury for the certainty of it.