Information for the General Public

Back to About Us

Also in this section:

• How to choose an investment manager
• Questions to ask an investment manager

Understanding investment risk

Your attitude to risk is a critical factor in creating and managing an investment portfolio. It is therefore vital that you and your investment manager understand what you both mean by risk. Many firms have developed systems to try and ensure that (i) they have a thorough understanding of your attitude to risk and (ii) that the portfolio they construct and manage for you is suitable for you and your investment objectives. A starting point is to explain the risk involved in different types of investment, which you can discuss with your investment manager in more detail. The appropriate allocation of funds between the various types of higher-risk and lower-risk investment is at the core of meeting your investment objectives and is a task which investment managers take seriously.

National Savings & Investments products

These include a range of products for planned savings and lump sum investment. There are ordinary accounts, investment accounts, deposit bonds, income bonds and savings certificates - including index-linked, some of which are tax-free.

The risk on such investments is negligible since they are guaranteed by the government. Interest rates fluctuate on deposit and investment accounts but are usually related to the prevailing base rate. National Savings products provide a relatively low return in terms of capital and/or income but are commensurately low risk. They have a role, then, as very low risk investments for risk-averse investors or as a low-risk element of an overall portfolio.

Building societies and banks

Investment in a bank or building society deposit account offers high security with relatively low returns. In the event of default, investors are protected by statutory compensation schemes that will refund any funds lost, but only up to specified limits. The income received depends on the type of account and in some circumstances payment of interest can be made without deduction of tax. The risk factor on deposit accounts is very low although the real return (i.e. the return in excess of inflation) is also likely to be low. Deposit accounts are useful for short-term investment or as a readily accessible emergency fund.

UK government securities ('gilts')

Bonds are tradeable debt securities and those issued by the UK government bear a rate of interest and, in most cases, a repayment date when (or a period within which) the bond will be repaid. Gilts may be bought through the London Stock Exchange or the National Savings Stock Register.

Like National Savings products, gilts benefit from the government's 'gilt-edged' guarantee. A gilt provides a fixed level of income, but its market price (and therefore the value of the income) depends on the outlook for interest rates and inflation, as well as the length of the gilt's remaining life until redemption. The risk of default is virtually zero, so the return on gilts held to redemption is again closely linked to prevailing and expected interest rates.

If a gilt is bought at a premium to its redemption value, it will obviously lose value if it is held to redemption, and this needs to be taken into account in working out its overall (capital as well as income) return. The income received from government stocks is fixed, except in the case of index-linked stocks where it is linked to movements in the retail price index.

Gilts can offer an element of low risk, secure return to a balanced portfolio.

Other fixed interest investments

The most common other fixed interest investments are bonds issued by companies (corporate bonds). Like gilts, they normally pay interest at a fixed rate and the capital is repayable on a specified date. Also, just like gilts, they are tradeable in the market. They are not to be confused, however, with the 'bonds' one sees advertised by banks and building societies offering a fixed interest return over, say, two years.

The risk factor on corporate bonds, as with gilts, is a function of inflation and prevailing interest rates but, unlike with gilts, there is also the very important question of the quality of the company issuing the bond. An investor needs to take a view on the ability of the company to meet both the capital and income obligations of its bonds on the due dates. While BP's bonds may be rated only a little below gilts, those of a young computer software company will be rated much lower and the company will need to pay a much higher rate of interest to attract investors to buy its bonds.

Companies' corporate advisers have developed even more exotic forms of finance, with, for example, fixed interest type securities with the ability to convert into equity on certain terms. Other more traditional forms of fixed interest investment include debentures, unsecured loan stock, preference shares and convertibles. Generally, bond holders have a prior call on companies' assets on liquidation, ahead of the shareholders.

Equities

Ordinary shares and ordinary stock units are that part of the capital of a company that generally has the lowest right to the company's assets and are therefore last in the queue for repayment on liquidation. They are therefore individually relatively high risk but, equally, shareholders are rewarded with participation in the growth in value of a company. Also, unlike the bondholders, they own the company and enjoy rights of control, such as voting at general meetings of the company.

Dealings in most UK-based equities are transacted through the London Stock Exchange and their prices are determined largely by market forces, which can be unpredictable. The success of a company, the size of its dividends and the degree of its exposure to general economic trends and foreign currencies all play a part in determining share price movements. Political, economic and regulatory factors can also affect share prices.

Equities are higher risk investments and the value of a share at any time largely depends upon how well investors in the stock market think both the company and the markets in which it is involved will perform in the future. Dividends are payable on shares but these are normally lower than income received from fixed interest investments, reflecting the possible capital growth that might be obtained. They can also be suspended during lean periods for the company.

Marketability of equities is another important factor in determining share price values. The shares of large FTSE 100 companies are usually easily traded in large volumes, while demand for and availability of shares in smaller companies can mean they are difficult to trade in (though this can also give rise to exploitable anomalies). This makes individual smaller companies generally riskier than large ones, if only because they can be difficult to sell.

At the extreme are shares in companies on the Alternative Investment Market (AIM) and off-exchange (OFEX) where liquidity and minimum listing requirements in terms of historic profitability and balance sheet strength are usually considerably less than the main market. The risk associated with such investments is consequently considerably higher than for a large quoted issue.

Convertibles

A convertible is usually a fixed interest security issued by a company, carrying the right to conversion into ordinary shares of the company at specified future dates according to a pre-determined formula. Conversion terms vary from company to company and it is up to the holder to decide whether to make the conversion or not.

The income received from convertibles is normally higher than that offered on the underlying ordinary shares, but the capital behaviour is different because of the right to convert to ordinary shares. Depending upon the proximity of the conversion date, interest rate factors can have a bearing on the capital value of convertibles. If the final conversion date passes, investors may find that the capital value of their investment has fallen and assumes the characteristics of a conventional fixed interest security. Alternatively, some convertibles may contain provisions for compulsory conversion or redemption, at the option of the issuing company, on terms that may not necessarily be advantageous to the holder.

Authorised unit trusts

These are collective investments enabling a pooling of relatively small individual investments to make up a balanced portfolio. Investors buy units in a fund suited to their particular requirements - i.e. high income, capital growth or specialising in a particular geographical area or activity. The risk depends upon the nature of the securities in which the fund is invested, and may be as great as with direct equity investment. But the wide spread of individual holdings or stocks in such a portfolio reduces the level of risk to a considerable extent. Unit trust funds are particularly suitable for small investors who are unable to achieve sufficient diversification by investing in individual equities. Unit trusts can pay an income depending upon the fund's underlying holdings and objectives.

Investment trusts

Investment trusts have many similarities to unit trusts in that, in their traditional form, they offer a collective investment with the expertise of professional fund managers. The difference is that an investment trust is a limited company with a fixed amount of capital or shares. An investment trust may also borrow additional funds and this can provide an element of 'gearing', which can enhance or hinder performance.

Investment trusts fall into three broad categories: general, specialist and split capital. A true general trust has no limitation on the area or industry in which its assets may be invested, whilst a specialist fund will have a narrower geographical or sectoral mandate. A split capital trust is an investment trust with more than one class of shares. These classes of share usually vary in terms of the return they can give investors - income or growth or both - and the risk attached to them. 'Splits' have been the source of much grief for many investors in recent years and the sector has dwindled in size. Many splits have complex structures and some have turned out to be very vulnerable to falling markets. Investment in many splits still offers an excellent choice and balance of risk and return, but a manager with specialist knowledge and experience is necessary.

OEICs

Open ended investment companies (OEICs) were introduced in 1997. They have some of the characteristics of both unit and investment trusts. They are designed to have greater appeal and familiarity, particularly to European investors who are unfamiliar with unit and investment trusts. There are a variety of general and specialist funds available. Many unit trusts have converted to this more flexible format and more are expected to follow. The most obvious difference to the investor is the single trading price rather than the more familiar bid-offer spread which for unit trusts can be particularly wide compared to quoted equities.

Exchange traded funds

Exchange traded funds (ETFs) are relatively new collective investment vehicles which track and give low cost exposure to the performance of an index. They are open-ended like unit trusts and they are listed on the stock exchange like an investment trust. As a hybrid of unit and investment trusts, they provide many of the best features of both but overcoming many of the problems inherent with either type of vehicle.

The benefits include increased flexibility and transparency for investors, instant diversification, low cost, and access to a market or sector in a single share. Existing ETFs in the UK do not normally attract stamp duty. ETFs can be bought and sold through regulated intermediaries during regular hours.

Alternatives

The investment markets are endlessly innovative and alternative investment classes and structures are being developed all the time, some of which become available to the private investor.

One class of investment that has hit the headlines recently, for both good and bad reasons, is hedge funds. These cover a vast array of strategies and markets, but share common characteristics, such as the ability to 'go short' (ie sell assets they don't actually own in the expectation that they will fall in price) as well as 'long' (ie buy assets in the traditional way) and to 'leverage' themselves (ie borrow to invest). The debate as to whether this makes hedge funds higher or lower risk investments is an endless one! But the better hedge funds should be able to deliver positive returns in all market conditions.

Structured products and funds are gaining ground as attractive investments for private clients and have been popular for a long time in Europe. Normally, they have a limited life of five or six years and they deliver a return linked to the performance of one or more major stockmarkets. They usually offer some protection on the downside if the chosen markets don't perform - often 100% of the original capital - by putting the majority of the cash investment on deposit, whilst using the balance to invest in derivatives (options etc) to provide a return at the redemption rate equal to or above the growth of the index or indices.

Several collective funds have preferred to come to the market recently as offshore-domiciled investment companies - similar to investment trusts, but with better tax-advantages and greater flexibility. Several specialist property companies in particular have chosen this route. In addition, under new legislation many mainstream property companies are re-constituting themselves as Real Estate Investment Trusts (REITs) to obtain significant tax advantages.

There are many others, but all alternative investments should only be bought with the confidence that you or your adviser or manager understands the structure of the investment and the nature of the risks involved.

The value of almost all investments may go down as well as up, so investors might not get back the amount originally invested. Past performance is not necessarily a guide to the future.