Inv- Risk 3- Ian McKeever & Co.

If you think the equity market is likely to have a bad time and the fixed interest market is going to have bad time as well because of weakening Sterling and weakening government finances, invest in cash deposits. It’s a high-risk strategy but if you are right the rewards should be very good indeed.

Cash is another asset class and has important uses in tactical asset allocation. However in most situations it is not low risk.

Minimising risk
Most people would consider investing all their assets in the shares of a single company as being risky and therefore they would not do it. However they would invest a significant proportion of their money in a single unit trust because they know that the unit price reflects the value of a portfolio of individual shares. Diversification reduces risks.

In practice most people drift into an investment strategy. That is to say that they start off with a number of deposit accounts, which they view as being completely safe. They are possibly not quite as safe as they think, but that is where they start. They then see that equities have produced a higher return and then they move a substantial part of their investments into equity and property investments. Later on they might go into higher risk investments either intentionally or possibly without realising how much they are moving up the scale of risk. However they frequently do not give much consideration to the risk intrinsic in individual investments and therefore to the risk intrinsic in their portfolio.

With luck, this results in a portfolio containing investments with a spread of risks and at least some diversification but generally everything is compartmentalised. Personal holdings may be spread between cash and equities with some property investment. Pension policies may be either invested entirely in equities or in some managed fund. The managed fund will probably contain some bonds. Although there may be some appreciation that risk is becoming less and less acceptable as retirement approaches, that will not be reflected in changes to the structure of the investment portfolio. Crucially there will be little appreciation that Gilts (Government bonds) represent the minimum risk investment for many people.

Although diversification reduces risk, market movements in the different markets are correlated. Economic growth increases the demand for and therefore the price of both property and commodities as well as being good for the equity market. Equally the markets affect each other. A property crisis can cause a banking crisis causing an economic crisis and therefore affecting equities and commodities. Prices do not necessarily move together. There are frequently time lags but for any investor diversifying away all risks is next to impossible.

Diversification works reasonably well most of the time, but has limitations when there are major economic shifts and there is contagion between markets. The problem is that even where there is only some risk there is no limit to the losses. There is no law that states that the equity market will not lose 90% of its value. It may be extremely unlikely but it is possible.

In normal circumstances losses in one market might be compensated by gains in another or at least, the losses in one market are contained because the investment in that market is itself limited. However once one markets start rapidly affecting each other that is no longer the case.

An alternative strategy is to invest say half or two-thirds of your money in the ultra-safe investments and the rest in very risky investments such as the capital shares in split capital investment trusts or maybe a hedge fund. If things go well they go very well. If they don't you have still got the money in the ultra-safe investment and at least you have had some excitement in the meantime.

If that sort of risk profile is attractive see exciting and tax favoured investments but understand that the risk of losing your entire investment is very real. Otherwise be in less risky investments where the risk of loss is very real but the risk of total loss is very small indeed.

More on Diversification.
Diversification works but its benefits are limited and are reached very quickly. Once again you need to know what you are diversifying away. There are several levels of risk:

Company risk associated with the management of the particular company.
Sector risk. If demand for houses falls all housebuilders will be affected.
Country Risk. If the UK stockmarket falls sentiment will affect all shares and anyway that would indicate falling economic growth in the UK which will affect most companies. Individual countries also have political risk’
Worldwide affects. If the world economy goes into recession all economies will be affected either directly or indirectly because of the fall in demand for exports.

Clearly there is scope for diversification by investing internationally rather than nationally. Through equities you can diversify across sectors and across countries. Although investing overseas is inevitably more expensive it is well worth going for that extra diversification.

Diversification into property and commodities will help but that does not help in a world-wide downturn. In achieving diversification it is important to realise that cash is another class of asset and therefore offers diversification particularly if that cash can be diversified into other currencies as well. However cash is not risk free and in that scenario the only thing that will protect you is being invested in you minimum risk asset or another asset very similar to it.

A Risk Strategy
Even within asset classes there are varying degrees of risk and you need to be aware of the degree of risk associated with each of your investments.

As mentioned above most people start with cash investments and move into equities slowly which is fine. As they become more comfortable with normal equities they move into more risky investment or more risky equities but not taking an overall view of their risk profile.

Conventional wisdom is to have a spread of investments covering either the full spectrum of risk or only part of it. However other strategies are possible. For example somer investors might ignore the ordinary equities and concentrate on the high risk end through tax favoured vehicles. This can be sensible strategy if the not only increases the proportion of his portfolio in high risk investments but also the proportion in low or zero risk investments.

This generally limits downside because for most investments you maximum loss is your initial investment. With such a portfolio whatever happens you still have the safe element of the portfolio and risks are therefore controlled. In some ways they are better controlled than with a portfolio including large holdings of more investments with average risk such as portfolio of ordinary equities. In that case the risk of total loss or virtually total loss may be small but it is still there.

Any investor’s risk control strategy must take account of two important factors

1 How much you can afford to lose.

2 Your ability to cut losses when the portfolio starts generating losses that approach that level of affordable losses. This has two elements. The first is the investor’s willingness to monitor his overall portfolio. The second is more subtle. It is about you being comfortable with selling your investments at loss in order to prevent further losses. We are talking about the ability to admit to yourself and possibly other people, such as your husband or wife, that in the event you got it wrong. It also means taking the risk that your current holdings might recover tomorrow and you might end up getting it doubly wrong. Ultimately this is the most difficult aspect of any risk management strategy to gauge as it involves knowing yourself and being honest about it.