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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.

 
Understand risk, price and time to invest better

The potential return on any investment is determined by a number of factors.

Some of the main drivers of return are:

  • Risk
  • Price
  • Time
  • Luck!

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.

Risk

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.

Price

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.

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6 comments so far. Why not have your say?

Dan Binks

Nov 26, 2012 at 16:52

I'd love to know where to get my hands on current and historic P/E data for various markets.

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ISA23

Nov 27, 2012 at 04:09

Excellent Article. Thank you so much for sharing this.

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Mike Deverell

Nov 27, 2012 at 08:43

Dan Blinks

Current PEs for all major markets are on FT market data and available for free (you might need to register). These PEs are based on historic earnings rather than projected earnings (historic PE rather than forward PE).

Unfortunately, historic data is not freely available and is very expensive to get hold of. The UK has a long term average PE of around 14. Most major markets have an average PE of somewhere between 13 and 16 times earnings. Hope this helps.

ISA23 - thanks for the nice comments!

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andrew r

Nov 27, 2012 at 09:27

The main risk is not knowing what you are doing.

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Rob Walker

Nov 27, 2012 at 11:52

Very interesting Mike - I wish I'd paid more attention in Maths classes now. However, in my simple world there are four aspects to P/E, that is Price, earnings, history and future potential. I'm only interested in price (vs historical price) and future potential. Often a temporary setback to a companies' fortunes is when I buy providing there is ample evidence that recovery is possible. (Lamprell, Wincanton, Cape and possible still Aviva fall into that category). The timescale of that recovery is unpredictable but I'll start selling when (and if) the price reaches my target. It may also be worth noting that companies in terminal decline will often have a favourable P/E because the big investors only want to sell leaving the price low compared to historic earnings - I don't think those factors were covered in this article and are of crucial importance.

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Chrisp

Nov 27, 2012 at 14:21

Quote "No rational investor would buy the riskier asset" Who ever suggested investors or markets are entirely rational ?

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