In the first part of this guide to understanding risk, which you can find here, we discussed how to determine your own appetite for risk and the different layers of risk you face when investing in the shares of an individual company.
In part 2 we now look at how to balance risk against potential return and the steps you can take to mitigate risk.
RATES OF RISK AND RETURN
It is important to consider how much risk is attached to your chosen investment and what level of reward you should expect in return.
The risk-free rate is usually defined as the yield on the benchmark 10-year UK Government bond, also known as gilt.
By buying one of these instruments you are lending the Government money and Britain has not failed to repay a debt since the reign of King Charles II.
At present gilt yields are depressed thanks to historically low interest rates so it may be more useful to consider the 10-year average of 3%.
WHAT IS THE EQUITY RISK PREMIUM?
Financial analysts will often talk about an 'equity risk premium'. This is the theoretical extra reward over and above the risk-free rate you should expect for investing in the stock market.
After all, equity investors are last in the order of creditors who will be repaid in the event of a company going out of business and, thus, likely to get nothing.
Typically, the equity risk premium could be anything between four to seven percentage points above the risk-free rate.
The table below looks at different asset classes and their risk profile. It is not intended to be a definitive guide is purely a hypothetical benchmark.
|Risk/reward profile for different assets|
|Risk (1-5, with 1 being the least risky and 5 being the riskiest)||Required annual return|
|Government bonds (risk-free rate)||1||3%|
|Small cap equities||4||30%|
|Biotech/natural resource explorers||5||50%+|
HOW TO MITIGATE RISK
There are ways you can limit and manage risk. A good solution is to run a diversified portfolio. This means if one holding or sector performs poorly you won’t lose everything.
Achieving diversification can be difficult if you do not have substantial amounts of capital at your disposal. A possible solution is an exchange-traded fund (ETF).
ETFs aim to replicate the performance of an index, sector or grouping of individuals stocks, bonds or commodities.
To meet with European legislation, an ETF must contain at least five or more underlying assets.
This inherent diversification means investors can access a whole market sector, region, theme, commodity basket or fixed income strategy in one simple trade.
THE BENEFITS OF USING A STOP LOSS
You can also limit your losses using stop loss orders. These can be set somewhere below the point at which you bought an individual stock – 20% is a good rule of thumb.
So, if you bought shares in Company X at 100p the stop would be set at 80p.
If the market falls and hits this predetermined stop price, an order will be triggered and the position automatically sold at the next available price. In fast-moving markets this can be below the level at which the stop loss is set.
As our risk/reward table above indicates, some industries and stock market sectors are higher risk than others so to limit risk you could avoid certain sectors or types of asset altogether.
Closely monitoring your portfolio is also important in terms of addressing risk. If a company you are invested in uses debt to fund a substantial acquisition, for example, then its risk profile will have changed.
Fundamentally you should only invest what you can afford to lose. So never invest borrowed money or cash which is needed to pay the mortgage or other essential bills. Also, it is important you understand the risks involved in any investment.
Do as much research as possible. You should never invest in anything you do not understand.