Investors often don’t notice risk until it becomes vitally important. In the past few years, when all financial markets have been buoyant, it has been easy to neglect good risk management. Why have a spread of assets when an S&P 500 tracker did so well? Why hold a range of sectors when technology shares have been dominant? However, 2020 showed why effective risk management is so important when investing.
The year 2020 threw everything at investors. There were sharp sell-offs as the pandemic hit, a significant rally in the technology sector, followed by a huge rotation into more economically sensitive areas, such as energy and banks. Fixed-income markets rallied and then sold off. Investors that weren’t managing risk effectively would have felt every bump in the road.
Professional investors tend to conflate risk with volatility. However, for most investors, volatility doesn’t matter very much, as long as it’s going in the right direction. For the majority of investors, the far greater risk is permanent loss of capital.
There are lots of risks that may give rise to long-term weakness in asset prices, all of which need to be factored in to an investor’s decision-making. Some are more obvious than others. For example, for many companies, there is always the risk that a weak economy compromises their ability to generate revenues and profits. Trade disputes and geopolitical tensions can also influence the outlook for specific companies. Even if no one can foresee a crisis such as the pandemic, a robust investment portfolio will always take into account the potential for the unexpected.
Other risks are easier to overlook. A portfolio may appear well balanced, spread across bonds, equities and other investments, but if many of the assets held are vulnerable to a shift in interest-rate expectations, investors may not be as protected as they think. The performance of long-dated government bonds and the technology sector, for example, are both linked to interest-rate expectations.
Climate change is another increasingly important risk factor. As governments strive to decarbonise their economies, polluting companies are likely to face larger fines and operational challenges. There will also be risks around liquidity and whether investors can get their money out when they need it and/or at the price they want.
The first question investors need to ask is how long they have to invest. The usual common-sense rules apply. In general, the longer investors have to invest, the more risk they can absorb. Markets will always have wobbles. The S&P 500 fell by around a third in March 2020 as it became clear that COVID-19 would not be isolated in Asia. By August, it had regained its previous level and by the end of the year, it was 400 points higher. Markets don’t always recover as quickly as this, but in general, they do recover.
This is why time is an investment superpower. As an investor, the key is not to be a forced seller in a difficult market. The longer an investor’s time frame, the more they can ride out short-term fluctuations in the market.
Investors also need to ask about the amount of risk they feel comfortable taking. With the caveat that holding large amounts in cash over long periods is not usually considered a great idea, there is also little point in holding higher-risk assets if it means constant worry. If any investor finds it difficult to tolerate shifts in the value of their capital, there are options. It may be possible to invest in lower-volatility companies (blue chips rather than smaller companies, for example) or lower-volatility markets (developed rather than emerging markets). It may be possible to divert capital towards fixed income or infrastructure, where there is less fluctuation in the capital.
Diversifying across a range of assets helps to manage risk in a portfolio. Having a carefully constructed portfolio of bonds, stock market investments and other areas such as property should ensure that if one part of a portfolio is doing badly, another is doing well. This helps even out the return over time.
This needs to be planned properly. It is not enough to assume that just because a portfolio has a spread of assets, it is effectively diversified. The correlation between different asset classes is fluid and can increase at times of crisis. It requires a nuanced analysis of both the current market environment and historical performance of individual assets in different economic climates.
Investors also need to be careful to minimise market risk. Putting a significant lump sum to work in the stock market in one go is a riskier option. Markets have cycles and there is a danger that the lump sum goes into the market just as it is hitting its peak, as investors who put money into the stock market at the height of the technology bubble in the late 1990s learnt to their cost.
This market risk can be mitigated by putting money into the market in smaller chunks. Investors pay a range of different prices, which helps smooth out their return over time. It can also help with some of the emotional aspects of investing for those that fear volatility.
It is also important to keep an eye on costs. If a fund manager is demonstrably adding value through judicious stock selection, it can be worth paying more. However, there are markets where it is difficult to beat the index consistently and there, a low-cost tracker fund may be more appropriate. Being careful on costs is an important risk management tool. As ever, investors need to ensure that if they are paying active fees, they are being rewarded in stronger performance.
Too often, investors only realise they haven’t been managing risk effectively when a crisis hits. The right advice can ensure that investors maintain a well-balanced and resilient portfolio that can see them through a range of different market conditions.
If you want to know more about how the financial planners at Tilney could help you, request a free-of-charge, initial consultation here or call them on 020 7189 2400.
This article does not constitute personal advice. If you are in doubt as to the suitability of an investment, please contact one of our advisers. The value of an investment may go down as well as up, and you may get back less than you originally invested.
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