In 1750 James Swaine bought a whip-making business in Piccadilly, and a Royal Appointment to King George III quickly followed. Over the next century the reputation and product range expanded and Swaine found himself providing bags and umbrellas to the aristocracy of the day. Today the company still uses time-honoured crafting processes for producing fine attaché cases and leather bags. At Charles Stanley we admire this considered way of doing business. Made for You David Coard FCSI Analyse the nature and impact of the main types of Investment Risk on Investment Performance. Investment Principles and Risk Gap 42-49
Transcript
In 1750 James Swaine bought a whip-making business in Piccadilly, and a Royal Appointment to King George III quickly followed. Over the next century the reputation and product range expanded and Swaine found himself providing bags and umbrellas to the aristocracy of the day. Today the company still uses time-honoured crafting processes for producing fine attaché cases and leather bags. At Charles Stanley we admire this considered way of doing business.
Made for You
David Coard FCSI
Analyse the nature and impact of the main types of Investment Risk on Investment Performance.
Investment Principles and Risk Gap 42-49
Format
14:00 – 14:10 Introduction
14:10 – 15:00 Main Session – Presented by David Coard
15:00 – 15:15 Break
15:15 – 15:40 Main session to continue
15:40 – 16:00 Q&A
Close
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‘Risk comes from not knowing what you’re doing’
Warren Buffet
Headline Topics
Liquidity & Access
Income & Capital Growth including shortfall
Short term volatility
Long Term performance
Gearing
Currency
Interest Rates
Systematic & Non-Systematic Risk, including fraud and counterparty, institutional, market timing
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What are the main categories of risk we should be concerned about when making any financial investment?
01 Aug 11 02 Aug 11 03 Aug 11 04 Aug 11 05 Aug 11 08 Aug 11 09 Aug 11 10 Aug 11 11 Aug 11 12 Aug 11 Source: Thomson Reuters Datastream
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Who should and should not be investing in these markets?
What do we mean by risk and what does a client mean by risk?
Do they correlate?
Risk
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Systematic Risk and Unsystematic Risk
Risk
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Systematic Risk
Systematic Risk – also known as Market Risks are those risks which
affect all companies within a market in one way or another.
For example:
Inflation Recession Interest Rates Political Instability Exchange Rates War Confidence
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Unsystematic Risk
Unsystematic Risk – also known as Specific Risk are risks which
are unique to the company.
Strength of Management ( Marks & Spencer) Range of Products (Unilever) Geographic Location (McDonald’s) Financial Position (B.P.) Innovational Factor (Apple)
Total Risk = Unsystematic Risk + Systematic Risk
Modern Portfolio Theory
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Modern Portfolio theory developed by Harry Markowitz in 1952 indicates that much of the unsystematic risk can be factored out by spreading funds over more investments.
How many is deemed to be the minimum?
15-20
Modern Portfolio theory states that 95% of the unsystematic risk can be eliminated with 20 securities
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Beta
One of key concepts of investment management and portfolio management is diversification.
You can diversify some of the portfolio risk away by investing in investments with different levels of risk measured by a company’s Beta.
Beta is the measure of the average historic volatility of a security’s return to the broader market risk and is stated as a proportion of the market risk.Beta for the whole market is deemed to be 1. A stock with a Beta of 1 is likely to move with the market. One with a Beta of 2 will move by twice the market – in both directions.
Beta < 1 – Stock described as defensive ( probably income producer)
Wage demands escalate as rise in cost of living is highlighted
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Risk
Risk
When was UK inflation (RPI) last in double figures?
10.9% in 1990
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Risk
27% in 1975
35% after the first World War
Changes in supply & demand can cause sudden rises or falls in prices – Middle East conflict in 1970s precipitated rapid increase in the oil price and thus inflation.
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What have the highest rates of inflation been in the last 100 years?
Risk
Those with high transport costs
Those with high staff costs (schools, nursing homes)
Others?
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What businesses are particularly vulnerable in times of high inflation?
Risk
What investors are most vulnerable in times of high inflation?
Cash depositors
Holders of fixed interest investments
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Inflation back in the headlines following quantitative easing (more on this later!)
Risk
Historically, which investments have benefited most from
inflation?
Shares
Property
Index-linked investments (government stock)
However, liquidity requirements may knock the ‘real’ assets theory off
course as there needs to be a buyer for a seller to realise his/her profit.
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Risk
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Income & Capital Growth – Risk of Shortfall Capital Growth – Risk of shortfall
Income & Capital Growth – Risk of shortfall
Capital
There is always a risk that an investor’s capital falls in value rather than grows, thus creating a shortfall – in real terms or in investor’s expectations –Know Your Client especially important in these circumstances.
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Income
Income may be cut through a company defaulting on its fixed interest payments or cutting its dividend through a drop in profitability. It may also not raise its dividend by sufficient each year to combat inflation.
The more certainty of income is required, the lower the level of income likely to be available or the more in-depth research will be required.
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Income & Capital Growth – Risk of shortfall
Risk
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Sentiment
Sentiment
‘Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it’
Warren Buffet
Not a factor to be ignored but impossible to quantify
Investors who believed gold, commodities, property, technology shares, antiques, fine art or even tulip bulbs could only go in one direction have been responsible for many crashes over the centuries.
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Risk
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Interest Rate Risk
Interest Rate Risk
What investments are put at greatest risk by a movement in interest rates?
Fixed Interest investments
Gold?
Others?
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10 year UK government bond index since 1990
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Source: Thomson Reuters Datastream
90 92 94 96 98 00 02 04 06 08 1080
100
120
140
160
180
80
100
120
140
160
180
UK BENCHMARK 10 YEAR DS GOVT. INDEX
Risk
Key factors in interest rate moves
The Economic Cycle
Government Fiscal Policy
Inflation Expectations
Preference for liquid investments
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Credit Risk
RiskStandard &
PoorsMoody’s Fitch
AAA Aaa AAA
AA+ Aa1 AA+
AA Aa2 AA
AA- Aa3 AA-
A+ A1 A+
A A2 A
A- A3 A-
BBB+ Baa1 BBB+
BBB Baa2 BBB
BBB- Baa3 BBB-
BB+ Ba1 BB+
BB Ba2 BB
BB- Ba3 BB-
B+ B1 B+
B B2 B
B- B3 B-
CCC Caa CCC
CC Ca CCC
C C CCC
D DDD
DD
D
Investment grade bonds
Non-investment grade / high yielding/
junk bonds
Credit Risk
Three types of credit risk?
Risk of default
Downgrade risk( US recently by one agency)
Credit spread risk
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Currency Risk
Risk
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SA Rand v Sterling - Over last 5 years
Source: Thomson Reuters Datastream
2007 2008 2009 2010 201110
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12
13
14
15
16
17
18
10
11
12
13
14
15
16
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SOUTH AFRICA RAND TO UK £ (WMR)
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Australian Dollar v Sterling - Over last 5 years
Source: Thomson Reuters Datastream
2007 2008 2009 2010 20111.4
1.6
1.8
2.0
2.2
2.4
2.6
1.4
1.6
1.8
2.0
2.2
2.4
2.6
AUSTRALIAN $ TO UK £ (WMR)
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Swiss Franc v Euro - Over last 5 years
Source: Thomson Reuters Datastream
2007 2008 2009 2010 20111.0
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.0
1.1
1.2
1.3
1.4
1.5
1.6
1.7
SWISS FRANC TO EURO (WMR)
Risk
Currency Risk?
When investments made in overseas quoted investments by a UK based
investor, there is the risk that the currency will move adversely.
Risk also applies to all UK quoted companies with large overseas interests
such as GlaxoSmithKline (approximately 90% of turnover outside UK) but
not to United Utilities (100% turnover in UK).
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Risk
When is this likely to occur?
Liquidity & Access Risk?
In times of uncertainty.
Liquidity & Access Risk
Particularly relates to smaller companies or unit trusts with assets that are not easy to trade. Market makers protect themselves by reducing the number of shares they will trade to the minimum stipulated by the Stock Exchange in that particular company. Might be 1000 shares at 25p each!
Asset classes such as commercial property companies and private equity (for example 3i) can also be vulnerable.
On a wider basis, residential property can go from being reasonably liquid to illiquid in a very short space of time. Thus access to liquidity can prove difficult.
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Risk
Event Risk
Examples?
9/11
Earthquake in Japan
Industrial Accident (B.P.)
In B.P.’s case, it was unable to pay its full dividend due to an unexpected event but it could happen as a result of a natural disaster, a corporate change or a regulatory one ( i.e. Hargreaves Lansdown having to adjust
its business model as a result of FSA ruling).
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Political Risk
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Risk
Political Risk
Relatively low in the UK these days (but Banking Sector?)
Danger if investing in, say, Egypt (Centamin Egypt)
Change of government creating new fiscal and monetary policies
Quantitative Easing
Change in taxation system
Nationalisation or confiscation of assets (Russia)
Until now, focused on market or portfolio risk – these are risks that lead to a fall in value resulting in an investor not meeting his/her risk and return objectives.
Operational risk looks at risks that arise from the investment process.
These include:
Counterparty/Settlement Risk - the counterparty (often institutional), to a transaction may fail to settle – Lehmans. Early structured products particularly vulnerable.
Fraud – internal or external – misappropriation of funds – Keydata - Madoff Misrepresentation – misleading reports & valuations (tend to come to light in a recession) System Failure Trading within institutions – trading errors and unauthorised trading - Nick Leeson at
‘Only when the tide goes out do you discover who’s been swimming naked’
Warren Buffet
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Risk
Market Timing
Timing and timescales are very important but very hard to predict short term movements. Luck is a factor whether you like to admit it or not. Essential to ensure the client understands that, if a long term investor rather than a short term trader, they need to be able to ‘ride out’ any volatility if investing in these markets.
Earlier chart showing FTSE movement in first half of August this year is a perfect example of volatility – possible to make or lose 10% in a day during that period.
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Risk
Diversification – Relative Risk
Key to reducing risk
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Return
Risk
Risk
Diversification – Relative Risk
What would you expect to be the types of investments at
the bottom of the line?
Cash Bank/Building Societies National Savings UK Government Stock Life Assurance Policies FTSE 100 Loan stocks Some collective investments Structured products ETFs
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Return
Risk
And the investments at the top of the line?
Listed shares Unlisted shares including AIM Property Loan stocks ( ex FTSE 100) Gold Other commodities VCT/EIS Some collective investments Structured products ETFs
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Diversification – Relative Risk
Return
Risk
‘Take calculated risks. That is quite different from being
rash’
General George S. Patton (American General in World War 1 & 11)
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Diversification – Relative Risk
Diversification can come in various forms
Different Asset classes can be held in portfolio – different betas to smooth out returns
Equity investment spread over world markets. Individual stock markets do not always move in the same direction although correlation has increased in recent years.
Use collective investments rather than individual companies although points 1 & 2 above still relevant.
Spread equity investment across the UK market to avoid reliance on any one sector (i.e, Banks). Do you give the same weighting to Royal Dutch Shell as to Hargreaves Lansdown?
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Diversification – Relative Risk
Top 5 FTSE companies by market cap
HSBC Holdings £95bn Vodafone Group £86bn BP £84bn Royal Dutch Shell £79bn GlaxoSmith Kline £69bn
Type of risk which involves either borrowing funds to increase the amount available for investment or buying an investment such as an investment trust warrant which will react by a greater percentage than the underlying investment. Options, CFDs and other derivatives have the same geared risk elements.
1. Investor has £2500 to invest
2. Sure investment is going to rise so borrows £2500 and invests £5000
3. Shares rise 50% so sell for £7500 and repays loan
4. Percentage profit 100% less loan costs.
However, if shares fall 50% investment wiped out plus costs of loan.
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Key points on risk
Systematic Risk is market risk whereas unsystematic risk refers to specific risk, or investment specific risk.
Inflation is a major risk for investors particularly those invested in cash deposits or fixed interest securities which are not index- linked. Real assets such as property and equities can provide some inflation protection.
Interest Rate risk is measured by duration, fixed interest securities will lose value when rates rise and vice versa. Fixed interest investments are also subject to credit risk.
Investors buying outside their base currency are taking on currency risk.
Other main risks are political, event, liquidity and operational risk.
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Risk
Key points on diversification
Diversification refers to combining risky investments in a way that reduces the overall risk of a portfolio.
Diversification can be carried out at the asset class or geographical level or by holding a diversified portfolio of securities within a single market.
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Diversification
Key points on gearing
Gearing or leverage will increase risk as it magnifies the losses or gains made by an investment when the price of the underlying asset moves.
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Gearing
Risk
‘The investor of today does not profit from yesterday’s
growth’
Warren Buffet
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Question time
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Important information
The information given in this presentation is based upon sources we believe to be reliable, but its accuracy cannot be guaranteed. The information does not constitute advice or a personal recommendation and you are recommended to seek advice concerning suitability from your investment advisor. Charles Stanley & Co. Limited and connected companies, their directors, members, employees and members of their families may have positions in the securities mentioned. Tax reliefs are those currently applying and the levels and bases of taxation can change. Investors should be aware that past performance is not necessarily a guide to the future and that the price of shares, and the income derived from them, may fall as well as rise and the amount realised may be less than their original sum.
Charles Stanley & Co. Limited is authorised and regulated by the Financial Services Authority.
Registered office 25 Luke St London EC2A 4AR. Registered in England number 1903304.
