Published 7 January 2010
Although your risk profile is a key element in determining the make up of your portfolio, I also find, in some circumstances, that over-focusing on the risk of each individual investment too early in the process can wrongly restrict your investment approach when it comes to achieving the overall objective i.e. a portfolio of investments that is right for you.
Let us assume that each investment has an unofficial "risk rating", which at least at the extremes, is easy to determine. If this is on a scale of 1 to 10, a rating of 1 being the lowest risk and 10 the highest, it does not take a financial genius to work out that cash is low risk and should be rated 1 and a CFD (Contracts For Difference) on an individual share would rate 10. However I do not believe the risk ratings of the individual investments should be the initial priority.
To begin with, the main point of focus should be
the blend and the balance of the overall portfolio. I would encourage
clients therefore to take a less fragmented view and adopt a holistic
approach to their investments. If for instance you are planning a road
trip from Liverpool to London you should not start with a roadmap of
Liverpool - there are simply too many roads, too many potential wrong
turnings and too many cul-de-sacs. You should start with a large map of
England and take the motorways until you get to the M25 and then you
get your A to Z of London out of the glove box! In the same way, you
should review your own risk appetite and the current balance of your
portfolio before you begin to assess the suitability of each individual
A key decision only you can make is where on the "risk ladder" you
currently sit. If it is on rung 1 then that is fine by me, providing
you appreciate the consequences of that decision. Anyone on that rating
would have to be totally focussed on the amount of money they have and
not the future value of it - in other words, the return of their
capital not a return on it. This may be right for some but not for all.
Equally if someone puts themselves on the top rung, as long as they can
sleep at night, that is fine with me.
For most of the clients I speak to, a risk rating somewhere
between 4 and 8 is far more common, and in most cases, more sensible if
it is achieved via a mix of asset classes and investments. However
there is often a disconnect between their assessment of their risk
appetite and the actual risk position of their portfolio. This can
happen for many reasons. It could be that the portfolio was built up in
a piecemeal fashion over many years or it could be a lack of
understanding or knowledge etc.
The devil is always in the detail but I find it
is best to keep away initially from individual assessments of the
investments until you have a more holistic view. Similar to a jigsaw,
it may be the individual pieces that make up the whole, but it is the
overall picture that has to be the starting point and always remember
as a self-directed investor it is your money, your jigsaw, your
picture, your portfolio!
Determining the starting position on the risk ladder that is right for you is a great way to begin. In Investment ViewPoint you will find that we discuss this in detail when we pose the question "What is your investment approach?”
Here we divide investor types into three broad categories based on the
"risk ratio" that most closely fits their position namely, Cautious, Moderate and Opportunistic.
Although the focus should initially be on the "bigger picture", it
has been assembled, as with a jigsaw, piece by piece and therefore a
risk assessment of the individual pieces also has to be completed. This
is where you have to be careful and force yourself, in effect, to be
“overly simplistic” - if you attempt to cover every angle you will
simply obscure the overall view.
I would be the first to admit that some of the assumptions I have
used to prepare the “risk table” below verge on the naive at times but
nevertheless I believe it has its merits as a starting point.
My own personal ratings would be; (1 = lowest risk, 10 = highest risk)
1. Cash and Gilts
2. Gilt Funds, Corporate Bonds and 100% capital-protected structured products
3. Corporate Bond Funds, structured products and Absolute Return Funds
4. Unit Trusts, OEICs and Exchange Traded Funds (ETFs)
5. Large Cap Shares (market cap over £1.8bil)
6. Mid Cap Shares (market cap £240mil to £1.8bil), Investment Trusts and REITS
8. Small Cap shares (less than £240mil market cap)
9. Covered warrants, Turbos and leveraged ETFs/ ETCs
10. CFDs, FST and FX
As I have stated already, but it is a caveat worth repeating, I am
the first person to acknowledge the weaknesses in my own ratings table.
For instance, it is technically wrong to include all unit trusts under
one risk rating as a Fund with a low beta can be a world of risk away
from those with a high beta. Are ETFs less risky than Funds? One
tracks, the other is managed, but does management increase risk or
reduce it? The questions I could pose would certainly outnumber the
products available but I have deliberately kept away from the detail.
This is a broad brush investment map and is not even going to show up
the A roads! What it loses in detail however, I believe it gains in
What concerns me is that many clients who can give me chapter and
verse on the investment attractions of a particular AIM stock, have not
given their overall risk rating a second thought. A simple example to
illustrate - somebody who assesses their overall risk rating as an 8
but who has an equal split of liquid capital in individual Gilts,
corporate bond funds and large cap stocks. They rate themselves an 8
and yet, according to my calculations they have a portfolio with an
overall rating of 3, a cautious investor. I am not suggesting that they
should immediately sell any of their investments but knowing the
mismatch between their risk appetite and their present portfolio will
at least act as a signpost for the direction of future changes.
Your risk palate
Another area of concern would be when clients do
have an appreciation of their overall risk appetite and indeed of the
risk rating of their individual investments but because of this they
back away from investments that do not fit on an individual basis.
Sometimes this can be opportunistic investors who do not consider
investments with a lower risk rating or perhaps more often, cautious
investors who rule out higher-risk options. This can needlessly limit
their choice, to the detriment of performance. It should not be a case
of "one size fits all". They should focus on the overall mix rather
than the individual risk ratings of each investment. It is a bit like
making a curry - whether you prefer them mild or red hot, it is good to
bear in mind that the basic ingredients remain the same, often the only
difference is the amount of spice added to the dish. So do not be put
off by individual options that would normally be outside your target
area, just make sure that the overall blend suits your risk palate.
Good luck with your investing!
Page last updated 7 January 2010