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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.
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.
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