Understanding the balance between risk and reward is fundamental to investing. You should be compensated for taking on risk with an appropriate level of reward.
In this first part of a two-part article we will look at how to determine your appetite for risk and the different types of risk you are exposed to.
In part two we will look at how to measure risk against potential return and some different ways of mitigating risk.
APPETITE FOR RISK
There is no such thing as a 100% risk-free investment and the ultimate risk of investing your capital is that you lose it.
Up to £85,000 held with a Financial Conduct Authority (FCA) authorised bank is protected by the Financial Services Compensation Scheme.
Investments do not enjoy this protection. However, it is worth remembering that if the best rates of interest are not keeping pace with the cost of living then the 'real' value of money will slowly be eroded.
Your appetite for risk depends on your investment goal or goals, time horizon and targeted return.
The rule of 100 offers a useful guide to asset allocation. Simply take 100 and subtract your age from it: the resulting figure represents the maximum percentage of your portfolio which should be placed in riskier assets like equities and commodities.
For example, a 30-year-old investing according to this rule might have 70% of their portfolio in equities and commodities and 30% in cash and bonds, while a 60-year-old could have around 40% in the stock market and 60% in the bank or invested in government bonds.
Ultimately, though, only you can judge what your idea of risk and satisfactory reward is.
THE RISKS FACED WHEN INVESTING IN A COMPANY
There are three key risks associated with an investment in an individual company:
Market risks: These are factors that fall outside of management’s control, such as interest rate rises, inflation and general economic conditions, or even a stock market crash.
Company risks: These are issues specific to the sector or individual firm, including competition for market share, pricing power, barriers to entry, management competence and financial strength. Key things to seek include growth in revenue, earnings and cash flow as well as margin performance.
Financial risk: Debt can be a killer. Interest payments reduce cash flow that could otherwise be invested in the core business or paid out in dividends to shareholders.
Look for net debt carried by a company. This is calculated by subtracting the value of a company’s cash from its debt and other liabilities such as pensions.
By comparing this against shareholders’ equity you can arrive at the net debt to equity ratio. If this number is negative you know the company has net cash at its disposal.
The ultimate arbiter of risk is a company’s share price.
Beta measures how much a stock moves by when the overall market rises or falls by 1%.
If a company has a beta of 1.5, the share price will, on average, move by 1.5% for every 1% change in the FTSE All-Share. It is possible to find the beta of some stocks on the finance sections of Google and Yahoo.
