Risk can be measured in many ways, none of which are entirely accurate as none of us have the benefit of perfect hindsight. It is also very subjective.
For many investors the biggest risk is one of capital loss. Any investment, including cash (banks do go bust from time to time) over the long term carries the risk of loss of some or all of the investor’s capital. There is no investment that generates a risk-free return.
By looking at the past behaviour of an investment or market, we can mathematically model the probability of different outcomes in the future, including the volatility of those returns. Generally speaking the higher the volatility displayed by an investment, the greater the risk of capital loss, but also the possibility of higher returns.
Cash has a very low volatility, as the main moving variable is interest rates and they don’t tend to move too much, too quickly, although, as we mentioned earlier, banks do go bust from time to time. Investments in gold mining shares on the other hand are very volatile, which historically has produced large gains and of course large losses. From October 2008 to September 2011 the NYSE Gold Shares index rose by 153% only to suffer losses in excess of 70% over the next 2 years; a high risk investment indeed!
Different funds will have different risk profiles, depending in what they invest.
At FundCalibre our research team assesses the overall risk of a fund by analysing a number of factors including: the fund's volatility within its sector; the level of risk involved in the region/sector in which the fund invests; the size of the companies within the fund; the number of stocks held; the risk controls imposed by the manager; the use of derivatives and currency issues. Once we have appraised a fund, we then assign it a FundCalibre Risk Rating, with 1 as the lowest risk and 10 the highest. However, even funds rated 1 are subject to risk.
The FundCalibre Risk Rating is simply a generic guide to the relative risk of all funds within the market.
The FundCalibre Risk Rating is shown in the form of a dial on each fund fact sheet like this:
Risk can also be interpreted in another way – that of not reaching your financial goal, or shortfall risk as we call it. For instance, if you are in your 20s and saving for retirement, there is the risk of not having enough money to retire on. In this instance, investing in cash, rather than equities, would increase your shortfall risk.
The longer the time horizon before you need to realise your investment the riskier you can afford to be, although obviously your personal attitude to risk is of paramount importance. For instance, if you are saving to pay off a mortgage, you may wish to have a higher risk profile in the early years when your investment has 25 years to run, but in later years a lower-risk strategy would be appropriate. This allows you to lock in previous years' gains.
As mentioned earlier, risks is very subjective and can differ greatly from one person to another. So assessing your own risk profile is important. Whilst a higher-risk approach is generally advocated for those with greater capital and a longer time horizon, an ability to accept risk is important. It is no good deciding that you are in a position to take a higher-risk approach, if such action causes endless sleepless nights when markets fall! If you are comfortable with short-term losses and happy to invest for a long period of time, then you might think of yourself as ‘Aggressive’. However, if swings in valuation worry you and perhaps you are closer to retirement, you might prefer to take a ‘Cautious’ stance.