Is it worth the risk?

3 June, 2020 | News

Anything you do financially will bear some kind of risk.

With ‘risk’ being a very emotive word, it is important that

any risk is well defined and quantified.

 

What is Investment Risk?

There are a number of investment risks, however, they all have the same principal concern; that your investments will not behave the way you want or need them to do.

 

What do we do about it?

I thought it may be useful to expand on how we, at Future Asset Management (FAM) quantify, assess and grade the investments we recommend to clients.

In the UK financial services industry, the main measure of risk is volatility. Many of the largest financial adviser and risk assessment tools use this as the sole measure of investment risk, however, at FAM we dig a little deeper………

Volatility is a measure of an investment’s price change over a given period of time. In mathematical terms, it is the ‘standard deviation’. The higher the volatility the larger the changes in valuation have been. We believe that using volatility as the only measure of risk can lead to some assets being incorrectly represented.

At FAM we use five additional measures of risk as well as volatility to help quantify and grade the risk of different investment assets. To measure these, we take different asset classes (such as UK larger companies/property/sector specific equities) performance since 1993. We currently risk grade over 30 different asset classes in order to assess our clients’ investments. The five additional measures of risk are:

 

  1. Worst Month: What was the worst month’s investment return experienced by that asset?
  2. Average Drawdown: Of all the negative investment periods, what was the average drawdown (drop in value)?
  3. Maximum Drawdown: What was the largest drop in investment value from peak to trough?
  4. Maximum Drawdown Period: This is the length of time the drawdown lasted, from peak to trough and then finally recovering to its original value.
  5. Liquidity: Does the asset possess any inherent liquidity risks? This is the risk that the asset may not be able to be realised or sold when required or without a significant penalty.

 

Here is an example of why volatility by itself could be misleading:

Property Investment funds have had a similar historic volatility as UK Equity and Bond     Income funds. This means many tools would class these assets as the same risk, however, if we look at the Maximum Drawdown since 1993, the property funds saw a drop of over 49%, while the UK Equity and Bond Income funds saw a drop of 31.5%. The Property funds would also have potential liquidity concerns if properties were unable to be sold.

We assess all six measures of risk across the 30+ assets and give each one a risk score. We then take any prospective investment solution for a client, break it down into these asset classes in order to establish the exposure to each level of risk to provide a weighted risk score for that investment solution.

 

Why take on these risks?

Taking risk within an investment is required in order to remove some of the other financial risks, such as:

  • Return Risk: The risk of not having sufficient returns to meet an objective.
  • Inflationary Risk: The risk that your assets will grow at a slower pace than inflation and reduce its buying power.
  • Risk of running out of money: If you are spending your money, some level of investment risk can make your funds last longer.
  • Income Risk: Having too little risk could mean the income being produced may not be sufficient for your requirements.

Our personal risk assessment will look to take into account your views on risk in conjunction with your personal circumstances and objectives (goals and aspirations included). This will allow us to determine a suitable level of investment risk for each situation. We then ensure the investment solution recommended meets this ascertained risk level.

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