How To Choose The Right ISA - Risk

Science has developed a myriad of ways to measure investment risk, some incorporating complex mathematics and some looking at the behaviour and psychology of investors. What is certainly clear is that the days of sticking a pin in somewhere on a scale of 1-10 is of little value when trying to measure your capacity to understand and tolerate risk. 

Before we look at how we carry out risk profiling, it makes sense to look at some of the main types of risk that an investor may face. 

• Capital Risk: When investors talk about risk it is probably safe to say that most will be concerned about the risk to their invested capital i.e. ‘can it go down, how far might it fall’ etc and whilst capital risk clearly exists, the fear of investing in real assets due to the risk of capital loss can often result in investors missing out on ‘real returns’.
   
• Liquidity Risk: Too many investors get caught out by having insufficient access to short term funds, being forced to sell invested assets at the wrong time.
   
• Inflation Risk: The concern that money will lose its real value in relation to inflation over time.
   
• Market Timing: Some investors try to forecast the highs and lows of markets and can end up being out of the market during periods of the best returns. 

Your risk tolerance is your ability, be it emotionally or financially, to withstand potential declines in the value of your portfolio in the short to medium term without succumbing to the urge or need to sell holdings at the wrong time. 

Detailed studies have shown that one of the most costly mistakes in long term investing is to be ‘out of the market’ when prices increase. Over the years the market has had more up days than down days. It follows therefore that if you step out of the market it is likely you will miss more up days than down days.  

As no one is able to predict the market timing of any rises, it’s likely that by the time you choose to re-enter the market, there would already have been a significant increase in values. 

If one adds in that a fundamental of long term investing is to buy low and not sell low, (something that can be achieved by periodical re-balancing), the logical conclusion is that in times of market stress, almost invariably, the right thing to do is nothing. 

One method to help you to work out how much risk you will be comfortable with is to use a questionnaire based tool. One tool is the Finametrica Risk Profiling system which is designed to help you determine where your boundaries lie in terms of what level of volatility you are prepared to accept. This ‘score’ enables us to identify a suitable asset allocation. 

Volatility 

Dictionary.com’s definition of volatility is: 

‘Tending to vary often or widely, as in price: the ups and downs of volatile stocks’. 

One of the key aspects of investing is to understand volatility and manage risk. 

If the markets simply rose steadily upward every day, investing would be a much easier proposition - one without risk. But in reality, the market is volatile, with ups and downs that affect your investments. Understanding volatility is important when developing an investment strategy - one that manages the inherent risk associated with investing.  

What contributes to volatility? 

There are a broad range of factors that influence the price of shares from companies (stocks) and other issuers, such as government agencies or municipalities (bonds):  

• Financial fundamentals: Fluctuations in profits, earnings and cash flow affect share prices. 
   
• Market psychology: Perceptions often influence the markets as much as reality. Optimism leads prices up, while uncertainty and negativism can cause a decline in a sector or the entire market. 
   
• Economic factors: Economic indicators (e.g., gross domestic product, employment, inflation), housing statistics, oil prices and industry-specific factors all affect investors. 
   
• Major events: Acquisitions, product innovations, corporate scandals, natural disasters and political changes can have a major influence on a company, industry or entire market 

Risk vs Return

Having established the correct allocation between equity, property and interest bearing securities for your portfolio, you should then apply modern techniques to ensure the greatest probability that you will earn the return that is appropriate for the level of risk that you are willing to assume.  

Action Point 

Before you make your next investment, it really does make sense to take a step back and evaluate how much risk you want to take.  

Many investors make the mistake of investing in ISAs every year in isolation from each other. They may choose different funds and fund managers, but the danger is that they end up with maybe tens of different funds all with alternative risk profiles.

The problem with this approach is that it becomes harder to monitor and review the portfolio over time and the opportunity cost of managing this number of investments is a big drag on the returns (whether positive or negative).  

If you have current investments or ISAs, or are about to make an investment, make sure you take the time to assess the volatility of the funds (ask the fund managers or your financial adviser) before you invest.

On the next post we'll look at asset allocation and deciding where to invest.