Investment Masterclass – Simplifying Risk

Ian King, Thursday December 19, 2013

In my last post I summarised a number of the various different risks which concern investors when either creating or reviewing their investment policy.

Investors are fortunate that, with careful management, a large number of these risks can be easily reduced or indeed eliminated. A number of different strategies are available to do this. Commonly, the process of diversification (spreading your investments across a range of different assets and opportunities) can be used to reduce a number of these risks. Careful cash flow projections and management can also help to protect the investor, for example if your investment strategy were to disappoint in the short-term.

Investment Risk

However, all investors must acknowledge that two specific risks remain and that they will be unable to eliminate both of these risks.  Whilst investors can seek to reduce one of the risks, they will as a result be required to take on more of the risk that remains.  The two key risks which concern all investors are:

  • Short-term volatility risk – the risk that your capital will decrease in nominal terms over a limited time period.
  • Inflation risk – the risk that when funds are withdrawn from the investment strategy they are unable to buy more goods and services than they would do if the funds were withdrawn today.

Short-Term Volatility

Those investors who are particularly concerned with short-term volatility risk frequently will focus their investment strategy towards assets which provide nominal capital security, for example cash deposits.  Historically, such assets have proven to be a poor hedge against inflation – thus the cautious investors’ common enemy of inflation risk.

Risk of Inflation

At the other end of the scale, some investors are more concerned with reducing the risk that inflation will reduce the buying power of their assets.  They will frequently construct their portfolio from real investments, commonly equities (otherwise known as shares).  The common drawback with such an approach is the inherent short-term volatile nature of such assets.

The Key Risks

We commonly speak with our clients in connection with these two key risks by using a scale of one to ten, where one would signify an approach which is solely concerned with reducing short-term volatility and ten for an investor who is solely focussed upon reducing inflation risk.

In my experience only one or two investors out of a hundred are truly either a one or ten on this scale, every other investor will be somewhere in the middle of this scale, i.e. they have concerns about both capital volatility and inflation risk.

We work with our clients to carefully position them on this scale.  Frequently investors who have varied investment objectives will have different judgements respective of the two risks for each objective.  Once a view has been agreed for each objective we create an investment policy which incorporates a mix of both nominal assets for capital protection and real assets for inflation protection.

In the posts which will follow I will go into more detail concerning some of the techniques and strategies which we employ when creating investment policies for our clients.

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