View the article online at http://citywire.co.uk/money/article/a637021
Understand risk, price and time to invest better
Use simple rules to decide when to rebalance your investments, writes Mike Deverell of Equilibrium Asset Management.
The potential return on any investment is determined by a number of factors.
Some of the main drivers of return are:
We can’t do anything about the fourth factor, but by understanding how the other three aspects interact, you can make returns much more predictable.
We all know that the greater the potential return, the greater the risk you will have to take.
It is worth thinking about why this is the case, since it illustrates how risk interacts with the other factors.
Assume there are two potential investments, each with the same potential return but one with greater risk than the other. No rational investor would buy the riskier asset. The price would decrease (therefore increasing potential return) until a point where the return is now worth that additional risk.
Risk in equities can be broken down into various categories. The more of these risks present, the greater the return required:
Stock specific risk – the risk that one stock will underperform another. This can be diversified away and should not be a problem in a properly constructed portfolio.
- Market risk – the risk that the market will fall. This can be mitigated by holding a diverse portfolio of assets like cash and bonds. Asset allocation is a key determinant of returns.
- Currency risk – the risk that currency movements will reduce returns. If your US stocks rise in value but the dollar falls, your returns are diluted.
- Political risk – the risk that politics will affect returns. The European debt crisis, corruption in Russia, or government interference in China, are all examples.
We require a much higher potential return from emerging markets, which arguably have all these risks, than we do from investing in the UK.
Risk needs considering in context with the other two factors that affect returns: price and time.
As explained earlier, risk is often reflected in the price. For example, the Chinese equity market currently trades on a multiple of 7.4 times earnings (the price/earnings ratio), whilst the UK trades on 11.8 times (source: Thomson Reuters Datastream). The Chinese market is ‘cheaper’ and arguably has a higher potential return than the UK, but with greater risk.
Price/earnings ratios are a key determinant of market returns. I stress market returns rather than stock specific returns, since individual shares are very unpredictable and many factors need taking into account.
News sponsored by:
From Brazil and Mexico, to Vietnam and Nigeria, the rapidly developing economies of Latin American and frontier markets, which are some of the smaller, less developed economies in the world, provides investors with a wealth of potential opportunities. Discover why BlackRock's investment trust range is well placed to help you make more of these exciting regions.
In this guide to investment trusts, produced in association with Aberdeen Asset Management, we spoke to many of the leading experts in the field to find out more.
More about this:
More from us
- Equilibrium Asset Management | Adviser Finder
- What QE means for your investment decisions
- Never trust an IFA? Why advice is undervalued
- How to generate an income from your savings
- Risk and return: how to strike the balance in your portfolio
- 5 golden rules of investing
- Buy low, sell high: in defence of the theory
- Buy low, sell high: we test the theory
- Why passive funds beat active management
- Sharpen your asset-allocation skills to profit from the volatility
- Unsafe havens in irrational markets
Tools from Citywire Money
From the Forums
Weekly email from The Lolly
Get simple, easy ways to make more from your money. Just enter your email address below
An error occured while subscribing your email. Please try again later.
Thank you for registering for your weekly newsletter from The Lolly.
Keep an eye out for us in your inbox, and please add firstname.lastname@example.org to your safe senders list so we don't get junked.