However, as an investor, there are several steps you can take to dampen the level of risk you are taking with your money.
1. Hold a number of different asset classes
FE Trustnet previously took a look at asset allocation – the process whereby an investor spreads their holdings among different assets in an effort to keep all their money from moving in the same direction, namely down, when unexpected events occur.
The idea is to spread the risk by buying things that tend to go up if other components in your portfolio go down.
However, there are a number of reasons why investors need to do more than just holding different asset classes, such as bonds and equities.
Jason Hollands (pictured), managing director of business development and communications at Bestinvest, says that for a start, the correlation between assets can change.
"Factors such as inflation and interest rates affect certain asset classes differently, so by diversifying your portfolio across a range of assets classes that are less correlated to each other you can reduce overall portfolio volatility." "The trouble is, in recent years many of these asset classes have become more correlated: gold has been behaving more like equities since exchange traded funds [ETFs] made it more easily tradable and we have seen greater synchronicity between equities and bonds."
Hollands says that this is likely to be a temporary state of affairs fuelled by government policies that will eventually change, and that more normal levels of correlation will probably return.
However, it does highlight the importance of being sophisticated in the way you run your portfolio, rather than sticking to over-simplistic models.
AWD Chase de Vere’s Patrick Connolly (pictured) says: "The behaviour of assets changes constantly and there are no guarantees. Take good-quality fixed interest investments like government bonds – who can say hand on heart what the potential downside is now?"
"They have been over-bought, and if they slip back to normal levels there’s the potential for capital loss, whereas in the past you would have bought them for capital preservation and felt pretty secure." 2. Spread your money across a variety of managers
Hollands explains that another problem with a simplistic asset allocation approach is that it ignores other risks that may appear from nowhere.
"It is also important to spread across a range of managers and funds to both reduce manager, provider-specific risk and style bias," he said.
He outlined a number of factors investors should take into account:
- Manager risk. Too much exposure to an individual manager or product could impact you if the manager goes off the boil, leaves, or makes bad decisions.
- Provider risk. Too much exposure to a single or small number of fund companies could impact you if the business faces a systemic problem. While retail funds are ring-fenced, so your assets are secure, managers may get distracted or suffer from poor morale if working at a business going through troubles.
- Style bias. Are you too focused on one investment style such as value managers?
- Gearing. Certain funds may use leverage to scale up their market exposure, including many investment trusts and absolute return funds. This is fine when decisions go the right way but they can also magnify losses.
- Liquidity. Certain asset classes and markets, as well as investment funds targeted at them, can see the ability to trade easily dry up in adverse market conditions. Heavy exposure to illiquid assets such as commercial property funds, private equity and venture capital funds, hedge funds and micro-cap companies means you run the risk of being unable to exit your investment quickly without potentially trading at unattractive prices.
3. Analyse the building blocks (individual funds)
While both Hollands and Connolly agree that investors need to look at the risk on their portfolio as a whole, they both explain that to do this you need to start by looking at the individual funds.
Investors have a number of quant-based metrics available to them to help them interpret risk on particular investments: volatility scores, Beta scores and FE Risk Scores, to name a few.
The volatility of a fund – usually given as an annual average – tells you how much a fund’s returns have deviated from the average performance figure.
If a fund has an average return of 5 per cent, for example, and a volatility of 15, it means that the range of its returns over the period has swung between +20 per cent and -10 per cent.
Hollands warns: "This [volatility] does, however, have limitations because it is based on past data, so it isn't predictive."
A fund’s Beta score measures how much its returns correlate to a particular benchmark.
This is useful in measuring risk as it helps to judge whether funds truly complement each other rather than exposing an investor to the same risks.
For example, let’s say you chose two funds from the IMA UK All Companies sector, one with a mid cap bias and the other a large cap focus, yet both had a Beta of around 0.9 to the FTSE All Share, within 0.1 or 0.2 of a percentage point of one another.
This would suggest that both were likely to perform in a similar way when the market went up or down (0.9 representing a strong correlation to the index) and would suggest you should diversify further to ensure you are not too exposed to a change in the All Share.
Beta measures how much an investment’s performance – and hence risk – departs from a particular benchmark, so requires selection of such an index.
Volatility, on the other hand, allows similar funds to be compared – the fact that a given equity fund has a higher volatility than a given bond fund is of no particular interest as bonds are generally less volatile.
4. Utilise risk-rating systems
FE Risk Scores attempt to make funds with very different focuses comparable by situating them in relation to a common benchmark – the FTSE 100.
A score of 100 means the fund is as volatile as the FTSE 100, while a score of 150 would make it 50 per cent more volatile.
The advantage of this way of looking at risk is that it is relative rather than absolute. This means that it takes into account the change in the volatility of the FTSE 100 and other investments over time.
Because the absolute levels of risk in markets naturally ebb and flow, risk levels by volatility can appear to change without there being significant changes to the fundamentals.
FE Risk Scores can also be produced for portfolios through FE Analytics, meaning that investors can create a portfolio with a certain risk rating.
Connolly stresses that ultimately, investors should always look at the level of their portfolio rather than on a fund-specific level.
He warns investors that there are no short-cuts past diversification, as predicting the performance of investments is a fool’s errand.
"There are no guarantees that funds will perform as investors expect, both to protect on the downside and provide growth potential, so it’s a balancing act," he said.